Foreign Exchange Trading - Forex Online Manual For Suscessful Trading

There are several reasons for the popularity of currency spot trading. Profits (or losses) are realized quickly in the spot market, due to market volatility. In addition, since spot deals mature in only two business days, the time exposure to credit risk is limited. Turnover in the spot market has been increasing dramatically, thanks to the combination of inherent profitability and reduced credit risk. The spot market is characterized by high liquidity and high volatility. Volatility is the degree to which the price of currency tends to fluctuate within a certain period of time. Free-floating currencies, such as theeuro or the Japanese yen, tend to be volatile against the U.S. dollar.

On-Line Manual
For Successful Trading
CONTENTS
Chapter 1. Introduction 7
1.1. Foreign Exchange as a Financial Market 7
1.2. Foreign Exchange in a Historical Perspective 8
1.3. Main Stages of Recent Foreign Exchange Development 9
The Bretton Woods Accord 9
The International Monetary Fund 9
Free-Floating of Currencies 10
The European Monetary Union 11
The European Monetary Cooperation Fund 12
The Euro 12
1.4. Factors Caused Foreign Exchange Volume Growth 13
Interest Rate Volatility 13
Business Internationalization 13
Increasing of Corporate Interest 13
Increasing of Traders Sophistication 13
Developments in Telecommunications 14
Computer and Programming Development 14
FOREX. On-line Manual For Successful Trading ii
Chapter 2. Kinds Of Major Currencies
and Exchange Systems 15
2.1. Major Currencies 15
The U.S. Dollar 15
The Euro 15
The Japanese Yen 16
The British Pound 16
The Swiss Franc 16
2.2. Kinds of Exchange Systems 17
Trading with Brokers 17
Direct Dealing 18
Dealing Systems 18
Matching Systems 18
2.3. The Federal Reserve System of the USA and
Central Banks of the Other G-7 Countries 20
The Federal Reserve System of the USA 20
The Central Banks of the Other G-7 Countries 21
Chapter 3. Kinds of Foreign Exchange Market 23
3.1. Spot Market 23
3.2. Forward Market 26
3.3. Futures Market 27
3.4. Currency Options 28
Delta 30
Gamma 30
Vega 30
Theta 31
FOREX. On-line Manual For Successful Trading iii
Chapter 4. Fundamental Analysis 32
4.1. Economic Fundamentals 32
Theories of Exchange Rate Determination 32
Purchasing Power Parity 32
The PPP Relative Version 33
Theory of Elasticities 33
Modern Monetary Theories on Short-term Exchange
Rate Volatility 33
The Portfolio-Balance Approach 34
Synthesis of Traditional and Modern Monetary Views 34
4.2. Economic Indicators 35
The Gross National Product (GNP) 35
The Gross Domestic Product (GDP) 35
Consumption Spending 36
Investment Spending 36
Government Spending 36
Net Trade 36
Industrial Production 36
Capacity Utilization 36
Factory Orders 37
Durable Goods Orders 37
Business Inventories 37
Construction Indicators 37
Inflation Indicators 38
Producer Price Index (PPI) 39
Consumer Price Index (CPI) 39
Gross National Product Implicit Deflator 39
Gross Domestic Product Implicit Deflator 39
Commodity Research Bureau's Futures Index (CRB Index) 39
The “Journal of Commerce” Industrial Price Index (Joc) 40
Merchandise Trade Balance 40
Employment Indicators 40
Employment Cost Index (ECI) 41
Consumer Spending Indicators 41
Auto Sales 41
Leading Indicators 42
Personal Income 42
4.3. Financial and Sociopolitical Factors 43
The Role of Financial Factors 43
Political Events and Crises 44
FOREX. On-line Manual For Successful Trading iv
Chapter 5. Technical Analysis 45
5.1. The Evolution and Fundamentals of Technical
Analysis Theory of Dow 45
Price 45
Volume and Open Interest 47
5.2. Types of Charts 49
Line Chart 49
Bar Chart 50
Candlestick Chart 51
5.3. Trends, Support and Resistance 53
Kinds of Trends 53
Percentage Retracement 55
The Trendline 55
Lines of Support and Resistance 57
5.4. Trend Reversal Patterns 59
Head-and-Shoulders 59
Signal Generated by the Head-and-shoulders Pattern 59
Inverse Head-and-Shoulders 61
Double Top 61
Signals Provided by the Double Top Formation 62
Double Bottom 63
Triple Top and Triple Bottom 63
The opposite is true for the triple bottom 64
Rounded Top and Bottom Formations 65
Diamond Formation 65
5.5. Trend Continuation Patterns 67
Flag Formation 67
Pennant Formation 67
Triangle Formation 70
Wedge Formation 75
Rectangle Formation 76
5.6. Gaps 78
Common Gaps 78
Breakaway Gaps 78
Runaway Gaps 79
Trading Signals for Runaway Gaps 79
Exhaustion Gaps 80
FOREX. On-line Manual For Successful Trading v
5.7. Mathematical Trading Methods (Indicators) 81
Moving Averages 81
Trading Signals of Moving Averages 83
Oscillators 84
Stochastics 85
Moving Average Convergence-Divergence (MACD) 86
Momentum 87
The Relative Strength Index (RSI) 88
Rate of Change (ROC) 89
Larry Williams %R 90
Commodity Channel Index (CCI) 90
Bollinger Bands 93
The Parabolic System (SAR) 93
The directional movement index (DMI) 93
Chapter 6. The Fibonacci Analysis and
Elliott Wave Theory 95
6.1. The Fibonacci Analysis 95
6.2. The Elliott Wave 96
Basics of Wave Analysis 96
Impulse Waves—Variations 98
The Diagonal Triangles 100
Failures (Truncated Fifths) 102
Chapter 7. Foreign Exchange Risks 104
7.1. Exchange Rate Risk 104
7.2. Interest Rate Risk 106
7.3. Credit Risk 107
7.4. Country Risk 108
Glossary And Foreign Exchange Terms 109
Bibliography 141
FOREX. On-line Manual For Successful Trading vi
CHAPTER 1
Introduction
1.1. Foreign Exchange as a Financial Market
Currency exchange is very attractive for both the corporate and individual
traders who make money on the Forex - a special financial market assigned for
the foreign exchange. The following features make this market different in
compare to all other sectors of the world financial system:
• heightened sensibility to a large and continuously changing number of
factors;
• accessibility to all traders in the major currencies;
• guaranteed quantity and liquidity of the major currencies;
• increased consideration for several currencies, round-the clock
business hours which enable traders to deal after normal hours or during
national holidays in their country finding markets abroad open and
• extremely high efficiency relative to other financial markets.
This goal of this manual is to introduce beginning traders to all the
essential aspects of foreign exchange in a practical manner and to be a source of
best answers on the typical questions as why are currencies being traded, who are
the traders, what currencies do they trade, what makes rates move, what
instruments are used for the trade, how a currency behavior can be forecasted and
where the pertinent information may be obtained from. Mastering the content of
an appropriate section the user will be able to make his/her own decisions, test
them, and ultimately use recommended tools and approaches for his/her own
benefit.
FOREX. On-line Manual For Successful Trading 7
1.2. Foreign Exchange in a Historical Perspective
Currency trading has a long history and can be traced back to the ancient
Middle East and Middle Ages when foreign exchange started to take shape after
the international merchant bankers devised bills of exchange, which were
transferable third-party payments that allowed flexibility and growth in foreign
exchange dealings.
The modern foreign exchange market characterized by the consequent
periods of increased volatility and relative stability formed itself in the twentieth
century. By the mid-1930s London became to be the leading center for foreign
exchange and the British pound served as the currency to trade and to keep as a
reserve currency. Because in the old times foreign exchange was traded on the
telex machines, or cable, the pound has generally the nickname “cable”. In 1930,
the Bank for International Settlements was established in Basel, Switzerland, to
oversee the financial efforts of the newly independent countries, emerged after
the World War I, and to provide monetary relief to countries experiencing
temporary balance of payments difficulties.
After the World War II, where the British economy was destroyed and the
United States was the only country unscarred by war, U.S. dollar became the
prominent currency of the entire globe. Nowadays, currencies all over the world
are generally quoted against the U.S. dollar.
FOREX. On-line Manual For Successful Trading 8
1.3. Main Stages of Recent Foreign Exchange
Development
The main phases of the further development of the Forex in modern
times were:
• signing of the Bretton Woods Accord;
• constitution of the international monetary fund (IMF);
• emergency of the free-floating foreign exchange markets;
• creation of currency reserves;
• constitution of the European Monetary Union and the European
Monetary Cooperation Fund;
• introduction of the Euro as a currency.
The Bretton Woods Accord was signed in July 1944 by the United States,
Great Britain, and France which agreed to make the currency market stable,
particularly due to governmental controls on currency values. In order to
implement it, two major goals were: emphasized: to provide the pegging
(backing of prices) of currencies and to organize the International Monetary Fund
(IMF).
In accordance to the Bretton Woods Accord, the major trading currencies
were pegged to the U.S. dollar in the sense that they were allowed to fluctuate
only one percent on either side of that rate. When a currency exceeded this
range, marked by intervention points, the central bank in charge had to buy it or
sell it, and thus bring it back into range. In turn, the U.S. dollar was pegged to
gold at $35 per ounce. Thus, the U.S. dollar became the world's reserve currency.
The purpose of IMF is to consult with one another to maintain a stable
system of buying and selling the currencies, so that payments in foreign
money can take place between countries smoothly and timely.
The IMF lends money to members who have trouble meeting financial
obligations to other members, on the condition that they undertake economic
reforms to eliminate these difficulties for their own good and the good of the
entire membership. In total the main tasks of the IMF are:
• to promote international cooperation by providing the means for
members to consult and collaborate on international monetary issues;
• to facilitate the growth of international trade and thus contribute to
high levels of employment and real income among member nations;
• to promote stability of exchange rates and orderly exchange
agreements, and [to] discourage competitive currency depreciation;
• to foster a multilateral system of international payments, and to seek
the elimination of exchange restrictions that hinder the growth of world trade;
• to make financial resources available to members, on a temporary
basis and with adequate safeguards, to permit them to correct payments
imbalances without resorting to measures destructive to national and international
prosperity.
FOREX. On-line Manual For Successful Trading 9
To execute these goals the IMF uses such instruments as Reserve tranche
which allows a member to draw on its own reserve asset quota at the time of
payment, Credit tranche drawings and stand-by arrangements are the standard
form of IMF loans, the compensatory financing facility extends financial help to
countries with temporary problems generated by reductions in export revenues,
the buffer stock financing facility which is geared toward assisting the stocking
up on primary commodities in order to ensure price stability in a specific
commodity and the extended facility designed to assist members with financial
problems in amounts or for periods exceeding the scope of the other facilities.
Since 1978 free-floating of currencies were officially mandated by the
International Monetary Fund. That is the currency may be traded by anybody and
its value is a function of the current supply and demand forces in the market, and
there are no specific intervention points that have to be observed. Of course, the
Federal Reserve Bank irregularly intervenes to change the value of the U.S.
dollar, but no specific levels are ever imposed. Naturally, free-floating
currencies are in the heaviest trading demand. Free-floating is not the sine qua
non condition for trading. Liquidity is also an indispensable condition.
A tool for people and corporations to protect investments in times of
economic or political instability is currency reserves for international
transactions. Immediately after the World War II the reserve currency worldwide
was the U.S. dollar. Currently there are other reserve currencies: the euro and
the Japanese yen. The portfolio of reserve currencies may change depending on
specific international conditions, for instance it may include the Swiss franc.
The creation of the European Monetary Union was the result of a long and
continuous series of post-World War II efforts aimed at creating closer economic
cooperation among the capitalist European countries. The European Community
(EC) commission's officially stated goals were to improve the inter-European
economic cooperation, create a regional area of monetary stability, and act as "a
pole of stability in world currency markets."
The first steps in this rebuilding were taken in 1950, when the European
Payment Union was instituted to facilitate the inter-European settlements of
international trade transactions. The purpose of the community was to promote
inter-European trade in general, and to eliminate restrictions on the trade of coal
and raw steel in particular.
In 1957, the Treaty of Rome established the European Economic
Community, with the same signatories as the European Coal and Steel
Community. The stated goal of the European Economic Community was to
eliminate customs duties and any barriers against the transit of capital, services,
and people among the member nations. The EC also started to raise common
tariff barriers against outsiders.
FOREX. On-line Manual For Successful Trading 10
The European Community consists of four executive and legislative bodies:
1. The European Commission. The executive body in charge of making
and observing the enforcement of the policies. Since it lacks an enforcement
arm, the commission must rely on individual governments to enforce the policies.
There are 23 departments, such as foreign affairs, competition policy, and
agriculture. Each country selects its own representatives for four-year terms. The
commission is based in Brussels and consists of 17 members.
2. The Council of Ministers. Makes the major policy decisions. It is
composed of ministers from the 12 member nations. The presidency is held for
six months by each of the members, in alphabetical order. The meetings take
place in Brussels or in the capital of the nation holding the presidency.
3. The European Parliament. Reviews and amends legislative proposals
and has the power to adopt or reject budget proposals. It consists of 518
elected members. It is based in Luxembourg, but the sessions take place in
Strasbourg or Brussels.
4. The European Court of Justice. Settles disputes between the EC and
the member nations. It consists of 13 members and is based in Luxembourg.
In 1963, the French-West German Treaty of Cooperation was signed. This
pact was designed not only to end centuries of bellicose rivalry, but also to
settle the postwar reconciliation between two major foes. The treat stipulated
that West Germany would lead economically through the cold war, and France,
the former diplomatic powerhouse, would provide the political leadership. The
premise of this treaty was obviously correct in an environment defined by a
foreseeable long-term continuing cold war and a divided Germany. Later in this
chapter, we discuss the implications for the modern era of this enormously
expensive pact.
A conference of national leaders in 1969 set the objective of establishing a
monetary union within the European Community. This goal was supposed to be
implemented by 1980, when a common currency was planned to be used in
Europe. The reasons for the proposed common currency unit were to stimulate
inter-European trade and to weld together the individual member economies in
order to compete successfully with the economies of the United States and
Japan.
In 1978, the nine members of the European Community ratified a new plan
for stability—the European Monetary System. The new system was practically
established in 1979. Seven countries were then full members—West
Germany, France, the Netherlands, Belgium, Luxembourg, Denmark, and
Ireland. Great Britain did not participate in all of the arrangements and Italy
joined under special conditions. Greece joined in 1981, Spain and Portugal in
1986. Great Britain joined the Exchange Rate Mechanism in 1990.
FOREX. On-line Manual For Successful Trading 11
The European Monetary Cooperation Fund was established to manage
the EMS' credit arrangements. In order to increase the acceptance of the
ECU, countries that hold more ECU deposits, or accept as loan repayment more
than their share of ECU, receive interest on the excess ECU deposits, and vice
versa. The interest rate is the weighted average of all the EMS members'
discount rates.
In 1998 the Euro was introduced as an all-European currency. Here are
the official locking rates of the 11 participating European currencies in the
euro (EUR). The rates were proposed by the EU Commission and approved by
EU finance ministers on December 31, 1998, ahead of the launch of the euro
at midnight, January 1, 1999.
The real starting date was Monday, January 4, 1999. The conversion
rates are:
1 EUR = 40.3399 BEF 1 EUR = 1.95583 DEM
1 EUR = 166.386 ESP 1 EUR = 6.55957 FRF
1 EUR = 0.787564 IEP 1 EUR = 1936.27 ITL
1 EUR = 40.3399 LUF 1 EUR = 2.20371 NLG
1 EUR = 13.7603 ATS 1 EUR = 200.482 PTE
1 EUR = 5.94573 FIM
The euro bills are issued in denominations of 5, 10, 20, 50, 100, 200,
and 500 euros. Coins are issued in denominations of 1 and 2 euros, and 50,
20,10, 5, 2, and 1 cent.
FOREX. On-line Manual For Successful Trading 12
1.4. Factors Caused Foreign Exchange Volume Growth
Foreign exchange trading is generally conducted in a decentralized manner,
with the exceptions of currency futures and options. Foreign exchange has
experienced spectacular growth in volume ever since currencies were allowed to
float freely against each other. While the daily turnover in 1977 was U.S. $5
billion, it increased to U.S. $600 billion in 1987, reached the U.S. $1 trillion mark
in September 1992, and stabilized at around $1,5 trillion by the year 2000.
Main factors influence on this spectacular growth in volume are indicated
below.
For foreign exchange, currency volatility is a prime factor in the growth
of volume. In fact, volatility is a sine qua non condition for trading. The only
instruments that may be profitable under conditions of low volatility are
currency options.
Interest Rate Volatility
Economic internationalization generated a significant impact on interest
rates as well. Economics became much more interrelated and that exacerbated the
need to change interest rates faster. Interest rates are generally changed in order
to adjust the growth in the economy, and interest rate differentials have a
substantial impact on exchange rates.
Business Internationalization
In recent decades the business world the competition has intensified,
triggering a worldwide hunt for more markets and cheaper raw materials and
labor. The pace of economic internationalization picked up even more in the
1990s, due to the fall of Communism in Europe and to up-and-down economic
and financial development in both Southeast Asia and South America. These
changes have been positive toward foreign exchange, since more transactional
layers were added.
Increasing of Corporate Interest
A successful performance of a product or service overseas may be pulled
down from the profit point of view by adverse foreign exchange conditions and
vice versa. An accurate handling of the foreign exchange may enhance the overall
international performance of a product or service. Proper handling of foreign
exchange generally adds substantially to the rate of return. Therefore, interest
in foreign exchange has increased in the past decade. Many corporations are
using currencies not only for hedging, but also for capitalizing on opportunities that
exist solely in the currency markets.
Increasing of Traders Sophistication
Advances in technology, computer software, and telecommunications and
increased experience have increased the level of traders' sophistication. This
FOREX. On-line Manual For Successful Trading 13
enhanced traders' confidence in their ability to both generate profits and
properly handle the exchange risks. Therefore, trading sophistication led toward
volume increase.
Developments in Telecommunications
The introduction of automated dealing systems in the 1980s, of matching
systems in the early 1990s, and of Internet trading in the late 1990s completely
altered the way foreign exchange was conducted. The dealing systems are on-
line computer systems that link banks on a one-to-one basis, while matching
systems are electronic brokers. They are reliable and much faster, allowing traders
to conduct more simultaneous trades. They are also safer, as traders are able to
see the deals that they execute. The dealing systems had a major role in
expanding the foreign exchange business due to their reliability, speed, and
safety.
Computer and Programming development
Computers play a significant role at many stages of conducting foreign
exchange. In addition to the dealing systems, matching systems simultaneously
connect all traders around the world, electronically duplicating the brokers'
market. The new office systems provide full accounting coverage, ticket writing,
back office processing, and risk management implementation at a fraction of their
previous cost. Advanced software makes it possible to generate all types of
charts, augment them with sophisticated technical studies, and put them at
traders' fingertips on a continuous basis at a rather limited cost.
FOREX. On-line Manual For Successful Trading 14
CHAPTER 2
Kinds Of Major Currencies
And Exchange Systems
2.1. Major Currencies
The U.S. Dollar
The United States dollar is the world's main currency. All currencies are
generally quoted in U.S. dollar terms. Under conditions of international economic
and political unrest, the U.S. dollar is the main safe-haven currency which was
proven particularly well during the Southeast Asian crisis of 1997-1998.
The U.S. dollar became the leading currency toward the end of the
Second World War and was at the center of the Bretton Woods Accord, as the
other currencies were virtually pegged against it. The introduction of the euro in
1999 reduced the dollar's importance only marginally.
The major currencies traded against the U.S. dollar are the euro,
Japanese yen, British pound, and Swiss franc.
The Euro
The euro was designed to become the premier currency in trading by
simply being quoted in American terms. Like the U.S. dollar, the euro has a
strong international presence stemming from members of the European
Monetary Union. The currency remains plagued by unequal growth, high
unemployment, and government resistance to structural changes. The pair was
also weighed in 1999 and 2000 by outflows from foreign investors, particularly
Japanese, who were forced to liquidate their losing investments in euro-
denominated assets. Moreover, European money managers rebalanced their
portfolios and reduced their euro exposure as their needs for hedging currency
risk in Europe declined.
FOREX. On-line Manual For Successful Trading 15
The Japanese Yen
The Japanese yen is the third most traded currency in the world; it has a
much smaller international presence than the U.S. dollar or the euro. The yen is
very liquid around the world, practically around the clock. The natural demand to
trade the yen concentrated mostly among the Japanese keiretsu, the economic
and financial conglomerates.
The yen is much more sensitive to the fortunes of the Nikkei index, the
Japanese stock market, and the real estate market. The attempt of the Bank of
Japan to deflate the double bubble in these two markets had a negative effect
on the Japanese yen, although the impact was short-lived
The British Pound
Until the end of World War II, the pound was the currency of reference. Its
nickname, cable, is derived from the telex machine, which was used to trade it
in its heyday. The currency is heavily traded against the euro and the U.S.
dollar, but has a spotty presence against other currencies. The two-year bout
with the Exchange Rate Mechanism, between 1990 and 1992, had a soothing
effect on the British pound, as it generally had to follow the deutsche mark's
fluctuations, but the crisis conditions that precipitated the pound's withdrawal from
the ERM had a psychological effect on the currency.
Prior to the introduction of the euro, both the pound benefited from any
doubts about the currency convergence. After the introduction of the euro, Bank
of England is attempting to bring the high U.K. rates closer to the lower rates in
the euro zone. The pound could join the euro in the early 2000s, provided that
the U.K. referendum is positive.
The Swiss Franc
The Swiss franc is the only currency of a major European country that
belongs neither to the European Monetary Union nor to the G-7 countries.
Although the Swiss economy is relatively small, the Swiss franc is one of the
four major currencies, closely resembling the strength and quality of the Swiss
economy and finance. Switzerland has a very close economic relationship with
Germany, and thus to the euro zone. Therefore, in terms of political uncertainty
in the East, the Swiss franc is favored generally over the euro.
Typically, it is believed that the Swiss franc is a stable currency.
Actually, from a foreign exchange point of view, the Swiss franc closely
resembles the patterns of the euro, but lacks its liquidity. As the demand for it
exceeds supply, the Swiss franc can be more volatile than the euro.
FOREX. On-line Manual For Successful Trading 16
2.2. Kinds of Exchange Systems
Trading with Brokers
Foreign exchange brokers, unlike equity brokers, do not take positions for
themselves; they only service banks. Their roles are:
• bringing together buyers and sellers in the market;
• optimizing the price they show to their customers;
• quickly, accurately, and faithfully executing the traders' orders.
The majority of the foreign exchange brokers execute business via phone.
The phone lines between brokers and banks are dedicated, or direct, and are
usually in-stalled free of charge by the broker. A foreign exchange brokerage
firm has direct lines to banks around the world. Most foreign exchange is
executed through an open box system—a microphone in front of the broker that
continuously transmits everything he or she says on the direct phone lines to the
speaker boxes in the banks. This way, all banks can hear all the deals being
executed. Because of the open box system used by brokers, a trader is able to
hear all prices quoted; whether the bid was hit or the offer taken; and the
following price. What the trader will not be able to hear is the amounts of
particular bids and offers and the names of the banks showing the prices. Prices
are anonymous the anonymity of the banks that are trading in the market ensures
the market's efficiency, as all banks have a fair chance to trade.
Brokers charge a commission that is paid equally by the buyer and the
seller. The fees are negotiated on an individual basis by the bank and the
brokerage firm.
Brokers show their customers the prices made by other customers either
two-way (bid and offer) prices or one way (bid or offer) prices from his or her
customers. Traders show different prices because they "read" the market
differently; they have different expectations and different interests. A broker who
has more than one price on one or both sides will automatically optimize the
price. In other words, the broker will always show the highest bid and the
lowest offer. Therefore, the market has access to the narrowest spread possible.
Fundamental and technical analyses are used for forecasting the future direction
of the currency. A trader might test the market by hitting a bid for a small
amount to see if there is any reaction.
Brokers cannot be forced into taking a principal's role if the name switch
takes longer than anticipated.
Another advantage of the brokers' market is that brokers might provide a
broader selection of banks to their customers. Some European and Asian banks
have overnight desks so their orders are usually placed with brokers who can deal
with the American banks, adding to the liquidity of the market.
FOREX. On-line Manual For Successful Trading 17
Direct Dealing
Direct dealing is based on trading reciprocity. A market maker—the bank
making or quoting a price—expects the bank that is calling to reciprocate with
respect to making a price when called upon. Direct dealing provides more trading
discretion, as compared to dealing in the brokers' market. Sometimes traders take
advantage of this characteristic.
Direct dealing used to be conducted mostly on the phone. Dealing errors
were difficult to prove and even more difficult to settle. In order to increase
dealing safety, most banks tapped the phone lines on which trading was
conducted. This measure was helpful in recording all the transaction details and
enabling the dealers to allocate the responsibility for errors fairly. But tape
recorders were unable to prevent trading errors. Direct dealing was forever
changed in the mid - 1980s, by the introduction of dealing systems.
Dealing Systems
Dealing systems are on-line computers that link the contributing banks
around the world on a one-on-one basis. The performance of dealing systems is
characterized by speed, reliability, and safety. Accessing a bank through a dealing
system is much faster than making a phone call. Dealing systems are
continuously being improved in order to offer maximum support to the dealer's
main function: trading. The software is very reliable in picking up the big figure of
the exchange rates and the standard value dates. In addition, it is extremely
precise and fast in contacting other parties, switching among conversations, and
accessing the database. The trader is in continuous visual contact with the
information exchanged on the monitor. It is easier to see than hear this
information, especially when switching among conversations.
Most banks use a combination of brokers and direct dealing systems. Both
approaches reach the same banks, but not the same parties, because
corporations, for instance, cannot deal in the brokers' market. Traders develop
personal relationships with both brokers and traders in the markets, but select
their trading medium based on price quality, not on personal feelings. The market
share between dealing systems and brokers fluctuates based on market
conditions. Fast market conditions are beneficial to dealing systems, whereas
regular market conditions are more beneficial to brokers.
Matching Systems
Unlike dealing systems, on which trading is not anonymous and is
conducted on a one-on-one basis, matching systems are anonymous and
individual traders deal against the rest of the market, similar to dealing in the
brokers' market. However, unlike the brokers' market, there are no individuals
to bring the prices to the market, and liquidity may be limited at times. Matching
systems are well-suited for trading smaller amounts as well.
The dealing systems characteristics of speed, reliability, and safety are
replicated in the matching systems. In addition, credit lines are automatically
FOREX. On-line Manual For Successful Trading 18
managed by the systems. Traders input the total credit line for each counter
party. When the credit line has been reached, the system automatically disallows
dealing with the particular party by displaying credit restrictions, or shows the
trader only the price made by banks that have open lines of credit. As soon as
the credit line is restored, the system allows the bank to deal again. In the
interbank market, traders deal directly with dealing systems, matching systems,
and brokers in a complementary fashion.
FOREX. On-line Manual For Successful Trading 19
2.3. The Federal Reserve System of the USA and
Central Banks of the Other G-7 Countries
The Federal Reserve System of the USA
Like the other central banks, the Federal Reserve of the USA affects the
foreign exchange markets in three general areas:
• the discount rate;
• the money market instruments;
• foreign exchange operations.
For the foreign exchange operations most significant are repurchase
agreements to sell the same security back at the same price at a predetermined
date in the future (usually within 15 days), and at a specific rate of interest. This
arrangement amounts to a temporary injection of reserves into the banking
system. The impact on the foreign exchange market is that the dollar should
weaken. The repurchase agreements may be either customer repos or system
repos.
Matched sale-purchase agreements are just the opposite of repurchase
agreements. When executing a matched sale-purchase agreement, the Fed sells
a security for immediate delivery to a dealer or a foreign central bank, with the
agreement to buy back the same security at the same price at a predetermined
time in the future (generally within 7 days). This arrangement amounts to a
temporary drain of reserves. The impact on the foreign exchange market is that
the dollar should strengthen.
The major central banks are involved in foreign exchange operations in
more ways than intervening in the open market. Their operations include payments
among central banks or to international agencies. In addition, the Federal Reserve
has entered a series of currency swap arrangements with other central banks since
1962. For instance, to help the allied war effort against Iraq's invasion of Kuwait in
1990-1991, payments were executed by the Bundesbank and Bank of Japan to the
Federal Reserve. Also, payments to the World bank or the United Nations are executed
through central banks.
Intervention in the United States foreign exchange markets by the U.S.
Treasury and the Federal Reserve is geared toward restoring orderly conditions
in the market or influencing the exchange rates. It is not geared toward
affecting the reserves.
There are two types of foreign exchange interventions: naked intervention
and sterilized intervention.
Naked intervention, or unsterilized intervention, refers to the sole foreign
exchange activity. All that takes place is the intervention itself, in which the
FOREX. On-line Manual For Successful Trading 20
Federal Reserve either buys or sells U.S. dollars against a foreign currency. In
addition to the impact on the foreign exchange market, there is also a monetary
effect on the money supply. If the money supply is impacted, then consequent
adjustments must be made in interest rates, in prices, and at all levels of the
economy. Therefore, a naked foreign exchange intervention has a long-term
effect.
Sterilized intervention neutralizes its impact on the money supply. As there
are rather few central banks that want the impact of their intervention in the
foreign exchange markets to affect all corners of their economy, sterilized
interventions have been the tool of choice. This holds true for the Federal
Reserve as well.
The sterilized intervention involves an additional step to the original
currency transaction. This step consists of a sale of government securities that
offsets the reserve addition that occurs due to the intervention. It may be easier
to visualize it if you think that the central bank will finance the sale of a currency
through the sale of a number of government securities.
Because a sterilized intervention only generates an impact on the supply
and demand of a certain currency, its impact will tend to have a short-to
medium-term effect.
The Central Banks of the Other G-7 Countries
In the wake of World War II, both Germany and Japan were helped to
develop new financial systems. Both countries created central banks that were
fundamentally similar to the Federal Reserve. Along the line, their scope was
customized to their domestic needs and they diverged from their model.
The European Central Bank was set up on June 1, 1998 to oversee the
ascent of the euro. During the transition to the third stage of economic and
monetary union (introduction of the single currency on January 1, 1999), it was
responsible for carrying out the Community's monetary policy. The ECB, which
is an independent entity, supervises the activity of individual member European
central banks, such as Deutsche Bundesbank, Banque de France, and Ufficio
Italiano dei Cambi. The ECB's decision-making bodies run a European System of
Central Banks whose task is to manage the money in circulation, conduct
foreign exchange operations, hold and manage the Member States' official foreign
reserves, and promote the smooth operation of payment systems. The ECB is
the successor to the European Monetary Institute (EMI).
The German central bank, widely known as the Bundesbank, was the
model for the ECB. The Bundesbank was a very independent entity, dedicated to
a stable currency, low inflation, and a controlled money supply. The
hyperinflation that developed in Germany after World War I created a fertile
economic and political scenario for the rise of an extremist political party and for
FOREX. On-line Manual For Successful Trading 21
the start of World War II. The Bundesbank's chapter obligated it to avoid any such
economic chaos.
The Bank of Japan has deviated from the Federal Reserve model in terms
of independence. Although its Policy Board is still fully in charge of monetary
policy, changes are still subject to the approval of the Ministry of Finance
(MOF). The BOJ targets the M2 aggregate. On a quarterly basis, the BOJ
releases its Tankan economic survey. Tankan is the Japanese equivalent of the
American tan book, which presents the state of the economy. The Tankan's
findings are not automatic triggers of monetary policy changes. Generally, the
lack of independence of a central bank signals inflation. This is not the case in
Japan, and it is yet another example of how different fiscal or economic policies
can have opposite effects in separate environments.
The Bank of England may be characterized as a less independent central
bank, because the government may overrule its decision. The BOE has not had an
easy tenure. Despite the fact that British inflation was high through 1991, reaching
double-digit rates in the late 1980s, the Bank of England did a marvelous job of
proving to the world that it was able to maneuver the pound into mirroring the
Exchange Rate Mechanism.
After joining the ERM late in 1990, the BOE was instrumental in keeping
the pound within its 6 percent allowed range against the deutsche mark, but the
pound had a short stay in the Exchange Rate Mechanism. The divergence
between the artificially high interest rates linked to ERM commitments and
Britain's weak domestic economy triggered a massive sell-off of the pound in
September 1992.
The Bank of France has joint responsibility, with the Ministry of Finance, to
conduct domestic monetary policy. Their main goals are non-inflationary growth
and external account equilibrium. France has become a major player in the
foreign exchange markets since the ravages of the ERM crisis of July 1993, when
the French franc fell victim to the foreign exchange markets.
The Bank of Italy is in charge of the monetary policy, financial
intermediaries, and foreign exchange. Like the other former European
Monetary System central banks, BOI's responsibilities shifted domestically
following the ERM crisis. Along with the Bundesbank and Bank of France, the Bank
of Italy is now part of the European System of Central Banks (ESCB).
The Bank of Canada is an independent central bank that has a tight rein on
its currency. Due to its complex economic relations with the United States, the
Canadian dollar has a strong connection to the U.S. dollar. The BOC intervenes
more frequently than the other G7 central banks to shore up the fluctuations of
its Canadian dollar. The central bank changed its intervention policy in 1999 after
admitting that its previous mechanical policy, of intervening in increments of
only $50 million at a set price based on the previous closing, was not working.
FOREX. On-line Manual For Successful Trading 22
CHAPTER 3
Kinds Of Foreign
Exchange Market
3.1. Spot Market
Currency spot trading is the most popular foreign currency instrument
around the world, making up 37 percent of the total activity (See Figure 3.1).
37%
57%
1%
5%
1 2 3 4
Figure 3.1.The market share of the foreign exchange instruments as of 1998:
1- spot; 2 – options; 3 – futures; 4 – forwards and swaps.
The fast-paced spot market is not for the fainthearted, as it features
high volatility and quick profits (and losses). A spot deal consists of a bilateral
contract whereby a party delivers a specified amount of a given currency
against receipt of a specified amount of another currency from a
counterparty, based on an agreed exchange rate, within two business days of
the deal date. The exception is the Canadian dollar, in which the spot delivery
is executed next business day.
FOREX. On-line Manual For Successful Trading 23
The name "spot" does not mean that the currency exchange occurs the
same business day the deal is executed. Currency transactions that require
same-day delivery are called cash transactions. The two-day spot delivery for
currencies was developed long before technological breakthroughs in
information processing.
This time period was necessary to check out all transactions' details
among counterparties. Although technologically feasible, the contemporary
markets did not find it necessary to reduce the time to make payments.
Human errors still occur and they need to be fixed before delivery. When
currency deliveries are made to the wrong party, fines are imposed.
In terms of volume, currencies around the world are traded mostly
against the U.S. dollar, because the U.S. dollar is the currency of reference.
The other major currencies are the euro, followed by the Japanese yen, the
British pound, and the Swiss franc. Other currencies with significant spot
market shares are the Canadian dollar and the Australian dollar.
In addition, a significant share of trading takes place in the currencies
crosses, a non-dollar instrument whereby foreign currencies are quoted
against other foreign currencies, such as euro against Japanese yen.
There are several reasons for the popularity of currency spot trading.
Profits (or losses) are realized quickly in the spot market, due to market
volatility. In addition, since spot deals mature in only two business days, the
time exposure to credit risk is limited. Turnover in the spot market has been
increasing dramatically, thanks to the combination of inherent profitability and
reduced credit risk. The spot market is characterized by high liquidity and
high volatility. Volatility is the degree to which the price of currency tends to
fluctuate within a certain period of time. Free-floating currencies, such as the
euro or the Japanese yen, tend to be volatile against the U.S. dollar.
In an active global trading day (24 hours), the euro/dollar exchange
rate may change its value 18,000 times. An exchange rate may "fly" 200 pips
in a matter of seconds if the market gets wind of a significant event. On the
other hand, the exchange rate may remain quite static for extended periods
of time, even in excess of an hour, when one market is almost finished
trading and waiting for the next market to take over. This is a common
occurrence toward the end of the New York trading day. Since California
failed in the late 1980s to provide the link between the New York and Tokyo
markets, there is a technical trading gap between around 4:30 pm and 6 pm
EDT. In the United States spot market, the majority of deals are executed
between 8 am and noon, when the New York and European markets overlap
(See Figure 3.2). The activity drops sharply in the afternoon, over 50 percent
in fact, when New York loses the international trading support. Overnight
trading is limited, as very few banks have overnight desks. Most of the banks
FOREX. On-line Manual For Successful Trading 24
send their overnight orders to branches or other banks that operate in the
active time zones.
29%
66% 5%
1 2 3
Figure 3.2. Distribution of the trading activity in the United States spot market in time: 1 –
transactions volume between 12 p.m. and 4 p.m.; 2 – between 4 p.m. and 8 p.m.; 3 – between 8
a.m. and 12 p.m.
The major traders in the spot market are the commercial banks and the
investment banks, followed by hedge funds and corporate customers. In the
interbank market, the majority of the deals are international, reflecting
worldwide exchange rate competition and advanced telecommunication
systems. However, corporate customers tend to focus their foreign exchange
activity domestically, or to trade through foreign banks operating in the same
time zone. Although the hedge funds' and corporate customers' business in
foreign exchange has been growing, banks remain the predominant trading
force.
The bottom line is important in all financial markets, but in currency
spot trading the antes always seem to be higher as a result of the demand
from all around the world.
The profit and loss can be either realized or unrealized. The realized
profit and loss is a certain amount of money netted when a position is closed.
The unrealized profit and loss consists of an uncertain amount of money that
an outstanding position would roughly generate if it were closed at the
current rate. The unrealized profit and loss changes continuously in tandem
with the exchange rate.
FOREX. On-line Manual For Successful Trading 25
3.2. Forward Market
The forward currency market consists of two instruments: forward
outright deals and swaps. A swap deal is unusual among the rest of the
foreign exchange instruments in the fact that it consists of two deals, or legs.
All the other transactions consist of single deals. In its original form, a swap
deal is a combination of a spot deal and a forward outright deal.
Generally, this market includes only cash transactions. Therefore,
currency futures contracts, although a special breed of forward outright
transactions, are analyzed separately.
According to figures published by the Bank for International
Settlements, the percentage share of the forward market was 57 percent in
1998 (See Figure 3.1). Translated into U.S. dollars, out of an estimated daily
gross turnover of US$1.49 trillion, the total forward market represents
US$900 billion.
In the forward market there is no norm with regard to the settlement
dates, which range from 3 days to 3 years. Volume in currency swaps longer
than one year tends to be light but, technically, there is no impediment to
making these deals. Any date past the spot date and within the above range
may be a forward settlement, provided that it is a valid business day for both
currencies. The forward markets are decentralized markets, with players
around the world entering into a variety of deals either on a one-on-one basis
or through brokers. In contrast, the currency futures market is a centralized
market, in which all the deals are executed on trading floors provided by
different exchanges.
Whereas in the futures market only a handful of foreign currencies may
be traded in multiples of standardized amounts, the forward markets are
open to any currencies in any amount. The forward price consists of two
significant parts: the spot exchange rate and the forward spread. The spot
rate is the main building block. The forward price is derived from the spot
price by adjusting the spot price with the forward spread, so it follows that
both forward outright and swap deals are derivative instruments. The forward
spread is also known as the forward points or the forward pips. The forward
spread is necessary for adjusting the spot rate for specific settlement dates
different from the spot date. It holds, then, that the maturity date is another
determining factor of the forward price. Just as in the case of the spot
market, the left side of the quote is the bid side, and the right side is the offer
side.
FOREX. On-line Manual For Successful Trading 26
3.3. Futures Market
Currency futures are specific types of forward outright deals which
occupy in general a small part of the Forex market (See Figure 3.1). Because
they are derived from the spot price, they are derivative instruments. They
are specific with regard to the expiration date and the size of the trade
amount. Whereas, generally, forward outright deals—those that mature past
the spot delivery date—will mature on any valid date in the two countries
whose currencies are being traded, standardized amounts of foreign currency
futures mature only on the third Wednesday of March, June, September, and
December.
There is a row of characteristics of currency futures, which make them
attractive. It is open to all market participants, individuals included. This is
different from the spot market, which is virtually closed to individuals - except
high net-worth individuals—because of the size of the currency amounts
traded. It is a central market, just as efficient as the cash market, and
whereas the cash market is a very decentralized market, futures trading takes
place under one roof. It eliminates the credit risk because the Chicago
Mercantile Exchange Clearinghouse acts as the buyer for every seller, and
vice versa. In turn, the Clearinghouse minimizes its own exposure by
requiring traders who maintain a non-profitable position to post margins equal
in size to their losses.
Moreover, currency futures provide several benefits for traders because
futures are special types of forward outright contracts, corporations can use
them for hedging purposes. Although the futures and spot markets trade
closely together, certain divergences between the two occur, generating
arbitraging opportunities. Gaps, volume, and open interest are significant
technical analysis tools solely available in the futures market. Yet their
significance extrapolates to the spot market as well.
Because of these benefits, currency futures trading volume has steadily
attracted a large variety of players.
For traders outside the exchange, the prices are available from on-line
monitors. The most popular pages are found on Bridge, Telerate, Reuters,
and Bloomberg. Telerate presents the currency futures on composite pages,
while Reuters and Bloomberg display currency futures on individual pages
shows the convergence between the futures and spot prices.
FOREX. On-line Manual For Successful Trading 27
3.4. Currency Options
A currency option is a contract between a buyer and a seller that gives
the buyer the right, but not the obligation, to trade a specific amount of
currency at a predetermined price and within a predetermined period of time,
regardless of the market price of the currency; and gives the seller, or writer,
the obligation to deliver the currency under the predetermined terms, if and
when the buyer wants to exercise the option.
Currency options are unique trading instruments, equally fit for
speculation and hedging. Options allow for a comprehensive customization of
each individual strategy, a quality of vital importance for the sophisticated
investor. More factors affect the option price relative to the prices of other
foreign currency instruments. Unlike spot or forwards, both high and low
volatility may generate a profit in the options market. For some, options are a
cheaper vehicle for currency trading. For others, options mean added security
and exact stop-loss order execution.
Currency options constitute the fastest-growing segment of the foreign
exchange market. As of April 1998, options represented 5 percent of the
foreign exchange market. (See Figure 3.1) The biggest options trading center
is the United States, followed by the United Kingdom and Japan. Options
prices are based on, or derived from, the cash instruments. Therefore, an
option is a derivative instrument. Options are usually mentioned vis-a-vis
insurance and hedging strategies. Often, however, traders have
misconceptions regarding both the difficulty and simplicity of using options.
There are also misconceptions regarding the capabilities of options.
In the currency markets, options are available on either cash or futures.
It follows, then, that they are traded either over-the-counter (OTC) or on the
centralized futures markets.
The majority of currency options, around 81 percent, are traded over-
the-counter. (See Figure 3.3) The over-the-counter market is similar to the
spot or swap market.
Corporations may call banks and banks will trade with each other either
directly or in the brokers' market. This type of dealing allows for maximum
flexibility: any amount, any currency, any odd expiration date, any time. The
currency amounts may be even or odd. The amounts may be quoted in either
U.S. dollars or foreign currencies.
Any currency may be traded as an option, not only the ones available as
futures contracts. Therefore, traders may quote on any exotic currency, as
required, including any cross currencies.
FOREX. On-line Manual For Successful Trading 28
19%
81%
1 2
Figure 3.3. Distribution of the options trading between over-the-counter (OTC) and the
organized exchange market: 1 – the share of OTC; 2 – the share of organized exchanges.
The expiration date may be quoted anywhere from several hours to
several years, although the bulk of dates are concentrated around the even
dates—one week, one month, two months, and so on. The cash market never
closes, so options may be traded literally around the clock.
Trading an option on currency futures will entitle the buyer to the right,
but not the obligation, to take physical possession of the currency future.
Unlike the currency futures, buying currency options does not require an
initiation margin. The option premium, or price, paid by the buyer to the
seller, or writer, reflects the buyer's total risk.
However, upon taking physical possession of the currency future by
exercising the option, a trader will have to deposit a margin.
Seven major factors have an impact on the option price:
1. Price of the currency.
2. Strike (exercise) price.
3. Volatility of the currency.
4. Expiration date.
5. Interest rate differential.
6. Call or put.
7. American or European option style.
The currency price is the central building block, as all the other factors
are compared and analyzed against it. It is the currency price behavior that
both generates the need for options and impacts on the profitability of
options.
The impact of the currency price on the option premium is measured by
delta, the first of the Greek letters used to describe aspects of the theoretical
pricing models in this discussion of factors determining the option price.
FOREX. On-line Manual For Successful Trading 29
Delta
Delta, or commonly A, is the first derivative of the option-pricing model
Delta may be viewed in three respects:
• as the change of the currency option price relative to a change in
the currency price. For instance, an option with a delta of 0.5 is
expected to move at one half the rate of change of the currency price.
Therefore, if the price of a currency goes up 10 percent, then the price
of an option on that particular currency is expected to rise by 5 percent.
• as the hedge ratio between the option contracts and the currency
futures contracts necessary to establish a neutral hedge. Therefore, an
option with a delta of 0.5 will need two option contracts for each of the
currency futures contracts.
• as the theoretical or equivalent share position. In this case, delta is
the number of currency futures contracts by which a call buyer is long
or a put buyer is short. If we use the same example of the delta of 5,
then the buyer of the put option is short half a currency futures
contract.
Traders may be unable to secure prices in the spot, forward outright, or
futures market, temporarily leaving the position delta unhedged. In order to
avoid the high cost of hedging and the risk of unusually high volatility, traders
may hedge their original options positions with other options. This method of
risk neutralization is called gamma or vega hedging.
Gamma
Gamma (Г) is also known as the curvature of the option. It is the
second derivative of the option-pricing model and is the rate of change of an
option's delta, or the sensitivity of the delta. For instance, an option with delta
= 0.5 and gamma = 0.05 is expected to have a delta = 0.55 if the currency
rises by 1 point, or a delta = 0.45 if the currency decreases by 1 point.
Gamma ranges between 0 percent and 100 percent. The higher the gamma,
the higher the sensitivity of the delta. It may therefore be useful to think of
gamma as the acceleration of the option relative to the movement of the
currency.
Vega
Vega gauges volatility impact on the option premium. Vega (<;) is the
sensitivity of the theoretical value of an option to a change in volatility. For
instance, a vega of 0.2 will generate a 0.2 percent increase in the premium
for each percentage increase in the volatility estimate, and a 0.2 percent
decrease in the premium for each percentage decrease in the volatility
estimate.
The option is traded for a predetermined period of time, and when this
time expires, there is a delivery date known as the expiration date. A buyer
who intends to exercise the option must inform the writer on or before
expiration. The buyer's failure to inform the writer about exercising the option
FOREX. On-line Manual For Successful Trading 30
frees the writer of any legal obligation. An option cannot be exercised past
the expiration date.
Theta
Theta (T), also known as time decay, occurs as the very slow or
nonexistent movement of the currency triggers losses in the option's
theoretical value.
For instance, a theta of 0.02 will generate a loss of 0.02 in the premium
for each day that the currency price is flat. Intrinsic value is not affected by
time, but extrinsic value is. Time decay accelerates as the option approaches
expiration, since the number of possible outcomes is continuously reduced as
the time passes.
Time has its maximum impact on at-the-money options and its
minimum effect on in-the-money options. Time's effect on out-of-the-money
options occurs somewhere within that range.
Bid-offer spreads in the market may make it too expensive to sell the
option and trade forward out rights.
If the option shifts deeply into the money, the interest rate differential
gained by early exercise may exceed the value of the option.
If the option amount is small or the expiration is close and the option
value only consists of the intrinsic value, it may be better to use the early
exercise.
Due to the complexity of its determining factors, option pricing is
difficult. In the absence of option pricing models, option trading is nothing but
inefficient gambling.
The one idea to make option pricing is that the option of buying the
domestic currency with a foreign currency at a certain price x is equivalent to
the option of selling the foreign currency with the domestic currency at the
same price x. Therefore, the call option in the domestic currency becomes the
put option in the other, and vice versa.
FOREX. On-line Manual For Successful Trading 31
CHAPTER 4
Fundamental Analysis
Two types of analysis are used for the market movements forecasting:
fundamental, and technical (the chart study of past behavior of commodity
prices). The fundamental one focuses on the theoretical models of exchange
rate determination and on the major economic factors and their likelihood of
affecting the foreign exchange rates.
4.1. Economic Fundamentals
Theories of Exchange Rate Determination
Fundamentals may be classified into economic factors, financial factors,
political factors, and crises. Economic factors differ from the other three
factors in terms of the certainty of their release. The dates and times of
economic data release are known well in advance, at least among the
industrialized nations. Below are given briefly several known theories of
exchange rate determination.
Purchasing Power Parity
Purchasing power parity states that the price of a good in one country
should equal the price of the same good in another country, exchanged at the
current rate—the law of one price. There are two versions of the purchasing
power parity theory: the absolute version and the relative version. Under the
absolute version, the exchange rate simply equals the ratio of the two
countries' general price levels, which is the weighted average of all goods
produced in a country. However, this version works only if it is possible to find
two countries, which produce or consume the same goods. Moreover, the
absolute version assumes that transportation costs and trade barriers are
insignificant. In reality, transportation costs are significant and dissimilar
around the world.
Trade barriers are still alive and well, sometimes obvious and
sometimes hidden, and they influence costs and goods distribution.
Finally, this version disregards the importance of brand names. For
example, cars are chosen not only based on the best price for the same type
of car, but also on the basis of the name ("You are what you drive").
FOREX. On-line Manual For Successful Trading 32
The PPP Relative Version
Under the relative version, the percentage change in the exchange rate
from a given base period must equal the difference between the percentage
change in the domestic price level and the percentage change in the foreign
price level. The relative version of the PPP is also not free of problems: it is
difficult or arbitrary to define the base period, trade restrictions remain a real
and thorny issue, just as with the absolute version, different price index
weighting and the inclusion of different products in the indexes make the
comparison difficult and in the long term, countries' internal price ratios may
change, causing the exchange rate to move away from the relative PPP.
In conclusion, the spot exchange rate moves independently of relative
domestic and foreign prices. In the short run, the exchange rate is influenced
by financial and not by commodity market conditions.
Theory of Elasticities
The theory of elasticities holds that the exchange rate is simply the
price of foreign exchange that maintains the balance of payments in
equilibrium. For instance, if the imports of country A are strong, then the
trade balance is weak. Consequently, the exchange rate rises, leading to the
growth of country A's exports, and triggers in turn a rise in its domestic
income, along with a decrease in its foreign income. Whereas a rise in the
domestic income (in country A) will trigger an increase in the domestic
consumption of both domestic and foreign goods and, therefore, more
demand for foreign currencies, a decrease in the foreign income (in country
B) will trigger a decrease in the domestic consumption of both country B's
domestic and foreign goods, and therefore less demand for its own currency.
The elasticities approach is not problem-free because in the short term
the exchange rate is more inelastic than it is in the long term and the
additional exchange rate variables arise continuously, changing the rules of
the game.
Modern Monetary Theories on Short-Term Exchange Rate Volatility
The modern monetary theories on short-term exchange rate volatility
take into consideration the short-term capital markets' role and the long-term
impact of the commodity markets on foreign exchange. These theories hold
that the divergence between the exchange rate and the purchasing power
parity is due to the supply and demand for financial assets and the
international capability.
One of the modern monetary theories states that exchange rate
volatility is triggered by a one-time domestic money supply increase, because
this is assumed to raise expectations of higher future monetary growth.
The purchasing power parity theory is extended to include the capital
markets. If, in both countries whose currencies are exchanged, the demand
FOREX. On-line Manual For Successful Trading 33
for money is determined by the level of domestic income and domestic
interest rates, then a higher income increases demand for transactions
balances while a higher interest rate increases the opportunity cost of holding
money, reducing the demand for money.
Under a second approach, the exchange rate adjusts instantaneously to
maintain continuous interest rate parity, but only in the long run to maintain
PPP.
Volatility occurs because the commodity markets adjust more slowly
than the financial markets. This version is known as the dynamic monetary
approach.
The Portfolio-Balance Approach
The portfolio-balance approach holds that currency demand is triggered
by the demand for financial assets, rather than the demand for the currency
per se.
Synthesis of Traditional and Modern Monetary Views
In order to better suit the previous theories to the realities of the
market, some of the more stringent conditions were adjusted into a synthesis
of the traditional and modern monetary theories.
A short-term capital outflow induced by a monetary shock creates a
payments imbalance that requires an exchange rate change to maintain
balance of payments equilibrium. Speculative forces, commodity markets
disturbances, and the existence of short-term capital mobility trigger the
exchange rate volatility. The degree of change in the exchange rate is a
function of consumers' elasticity of demand.
Because the financial markets adjust faster than the commodities
markets, the exchange rate tends to be affected in the short term by capital
market changes, and in the long term by commodities changes.
FOREX. On-line Manual For Successful Trading 34
4.2. Economic Indicators
Economic indicators occur in a steady stream, at certain times, and a
little more often than changes in interest rates, governments, or natural
activity such as earthquakes etc. Economic data is generally (except of the
Gross Domestic Product and the Employment Cost Index, which are released
quarterly) released on a monthly basis.
All economic indicators are released in pairs. The first number reflects
the latest period. The second number is the revised figure for the month prior
to the latest period. For instance, in July, economic data is released for the
month of June, the latest period. In addition, the release includes the revision
of the same economic indicator figure for the month of May. The reason for
the revision is that the department in charge of the economic statistics
compilation is in a better position to gather more information in a month's
time. This feature is important for traders. If the figure for an economic
indicator is better than expected by 0.4 percent for the past month, but the
previous month's number is revised lower by 0.4 percent, then traders are
likely to ignore the overall release of that specific economic data.
Economic indicators are released at different times. In the United
States, economic data is generally released at 8:30 and 10 am ET. It is
important to remember that the most significant data for foreign exchange is
released at 8:30 am ET. In order to allow time for last-minute adjustments,
the United States currency futures markets open at 8:20 am ET.
Information on upcoming economic indicators is published in all leading
newspapers, such as the Wall Street Journal, the Financial Times, and the
New York Times; and business magazines, such as Business Week. More
often than not, traders use the monitor sources—Bridge Information Systems,
Reuters, or Bloomberg—to gather information both from news publications
and from the sources' own up-to-date information.
The Gross National Product (GNP)
The Gross National Product measures the economic performance of the
whole economy.
This indicator consists, at macro scale, of the sum of consumption
spending, investment spending, government spending, and net trade. The
gross national product refers to the sum of all goods and services produced
by United States residents, either in the United States or abroad.
The Gross Domestic Product (GDP)
The Gross Domestic Product (GDP) refers to the sum of all goods and
services produced in the United States, either by domestic or foreign
companies. The differences between the two are nominal in the case of the
economy of the United States. GDP figures are more popular outside the
FOREX. On-line Manual For Successful Trading 35
United States. In order to make it easier to compare the performances of
different economies, the United States also releases GDP figures.
Consumption Spending
Consumption is made possible by personal income and discretionary
income. The decision by consumers to spend or to save is psychological in
nature. Consumer confidence is also measured as an important indicator of
the propensity of consumers who have discretionary income to switch from
saving to buying.
Investment Spending
Investment—or gross private domestic spending - consists of fixed
investment and inventories.
Government Spending
Government spending is very influential in terms of both sheer size and
its impact on other economic indicators, due to special expenditures. For
instance, United States military expenditures had a significant role in total
U.S. employment until 1990. The defense cuts that occurred at the time
increased unemployment figures in the short run.
Net Trade
Net trade is another major component of the GNP. Worldwide
internationalization and the economic and political developments since 1980
have had a sharp impact on the United States' ability to compete overseas.
The U.S. trade deficit of the past decades has slowed down the overall GNP.
GNP can be approached in two ways: flow of product and flow of cost.
Industrial Production
Industrial production consists of the total output of a nation's plants,
utilities, and mines. From a fundamental point of view, it is an important
economic indicator that reflects the strength of the economy, and by
extrapolation, the strength of a specific currency. Therefore, foreign exchange
traders use this economic indicator as a potential trading signal.
Capacity Utilization
Capacity utilization consists of total industrial output divided by total
production capability. The term refers to the maximum level of output a plant
can generate under normal business conditions. In general, capacity
utilization is not a major economic indicator for the foreign exchange market.
However, there are instances when its economic implications are useful
for fundamental analysis. A "normal" figure for a steady economy is 81.5
percent. If the figure reads 85 percent or more, the data suggests that the
industrial production is overheating, that the economy is close to full capacity.
High capacity utilization rates precede inflation, and expectation in the foreign
FOREX. On-line Manual For Successful Trading 36
exchange market is that the central bank will raise interest rates in order to
avoid or fight inflation.
Factory Orders
Factory orders refer to the total of durable and nondurable goods
orders. Nondurable goods consist of food, clothing, light industrial products,
and products designed for the maintenance of durable goods. Durable goods
orders are discussed separately. The factory orders indicator has limited
significance for foreign exchange traders.
Durable Goods Orders
Durable goods orders consist of products with a life span of more than
three years. Examples of durable goods are autos, appliances, furniture,
jewelry, and toys. They are divided into four major categories: primary
metals, machinery, electrical machinery, and transportation.
In order to eliminate the volatility pertinent to large military orders, the
indicator includes a breakdown of the orders between defense and non-
defense.
This data is fairly important to foreign exchange markets because it
gives a good indication of consumer confidence. Because durable goods cost
more than nondurables, a high number in this indicator shows consumers'
propensity to spend. Therefore, a good figure is generally bullish for the
domestic currency.
Business Inventories
Business inventories consist of items produced and held for future sale.
The compilation of this information is facile and holds little surprise for the
market. Moreover, financial management and computerization help control
business inventories in unprecedented ways. Therefore, the importance of
this indicator for foreign exchange traders is limited.
Construction Indicators
Construction indicators constitute significant economic indicators that
are included in the calculation of the GDP of the United States. Moreover,
housing has traditionally been the engine that pulled the U.S. economy out of
recessions after World War II. These indicators are classified into three major
categories:
1. housing starts and permits;
2. new and existing one-family home sales and
3. construction spending.
Private housing is monitored closely at all the major stages. (See Figure
4.1.) Private housing is classified based on the number of units (one, two,
three, four, five, or more); region (Northeast, West, Midwest, and South);
and inside or outside metropolitan statistical areas.
FOREX. On-line Manual For Successful Trading 37
Figure 4.1. Diagram of construction of private housing
Construction indicators are cyclical and very sensitive to the level of
interest rates (and consequently mortgage rates) and the level of disposable
income. Low interest rates alone may not be able to generate a high demand
for housing, though. As the situation in the early 1990s demonstrated, despite
historically low mortgage rates in the United States, housing increased only
marginally, as a result of the lack of job security in a weak economy.
Housing starts between one and a half and two million units reflect a
strong economy, whereas a figure of approximately one million units suggests
that the economy is in recession.
Inflation Indicators
The rate of inflation is the widespread rise in prices. Therefore, gauging
inflation is a vital macroeconomic task. Traders watch the development of
inflation closely, because the method of choice for fighting inflation is raising
the interest rates, and higher interest rates tend to support the local currency.
Moreover, the inflation rate is used to "deflate" nominal interest rates and the
GNP or GDP to their real values in order to achieve a more accurate measure
of the data.
The values of the real interest rates or real GNP and GDP are of the
utmost importance to the money managers and traders of international
financial instruments, allowing them to accurately compare opportunities
worldwide.
To measure inflation traders use following economic tools:
• Producer Price Index (PPI);
• Consumer Price Index (CPI);
• GNP Deflator;
• GDP Deflator;
• Employment Cost Index (ECI);
• Commodity Research Bureau's Index (CRB Index);
• Journal of Commerce Industrial Price Index (JoC).
FOREX. On-line Manual For Successful Trading 38
The first four are strictly economic indicators; they are released at
specific intervals. The commodity indexes provide information on inflation
quickly and continuously.
Other economic data that measure inflation are unemployment,
consumer prices, and capacity utilization.
Producer Price Index (PPI)
Producer price index is compiled from most sectors of the economy,
such as manufacturing, mining, and agriculture. The sample used to calculate
the index contains about 3400 commodities. The weights used for the
calculation of the index for some of the most important groups are: food - 24
percent; fuel - 7 percent; autos - 7 percent; and clothing - 6 percent. Unlike
the CPI, the PPI does not include imported goods, services, or taxes.
Consumer Price Index (CPI)
Consumer price index reflects the average change in retail prices for a
fixed market basket of goods and services. The CPI data is compiled from a
sample of prices for food, shelter, clothing, fuel, transportation, and medical
services that people purchase on daily basis. The weights attached for the
calculation of the index to the most important groups are: housing - 38
percent; food - 19 percent; fuel - 8 percent; and autos - 7 percent.
The two indexes, PPI and CPI, are instrumental in helping traders
measure inflationary activity, although the Federal Reserve takes the position
that the indexes overstate the strength of inflation.
Gross National Product Implicit Deflator
Gross national product implicit deflator is calculated by dividing the
current dollar GNP figure by the constant dollar GNP figure.
Gross Domestic Product Implicit
Gross domestic product implicit deflator is calculated by dividing the
current dollar GDP figure by the constant dollar GDP figure.
Both the GNP and GDP implicit deflators are released quarterly, along
with the respective GNP and GDP figures. The implicit deflators are generally
regarded as the most significant measure of inflation.
Commodity Research Bureau's Futures Index (CRB index)
The Commodity Research Bureau's Futures Index makes watching for
inflationary trends easier. The CRB Index consists of the equally weighted
futures prices of 21 commodities. The components of the CRB Index are:
• precious metals: gold, silver, platinum;
• industrials: crude oil, heating oil, unleaded gas, lumber, copper,
and cotton;
• grains: corn, wheat, soybeans, soy meal, soy oil;
FOREX. On-line Manual For Successful Trading 39
• livestock and meat: cattle, hogs, and pork bellies;
• imports: coffee, cocoa, sugar;
• miscellaneous: orange juice.
The preponderance of food commodities makes the CRB Index less
reliable in terms of general inflation. Nevertheless, the index is a popular tool
that has proved quite reliable since the late 1980s.
The “Journal of commerce” Industrial Price Index (JoC)
The “Journal of commerce” industrial price index consists of the prices
of 18 industrial materials and supplies processed in the initial stages of
manufacturing, building, and energy production. It is more sensitive than
other indexes, as it was designed to signal changes in inflation prior to the
other price indexes.
Merchandise Trade Balance
is one of the most important economic indicators. Its value may trigger
long-lasting changes in monetary and foreign policies. The trade balance
consists of the net difference between the exports and imports of a certain
economy. The data includes six categories:
1. food;
2. raw materials and industrial supplies;
3. consumer goods;
4. autos;
5. capital goods;
6. other merchandise.
Employment Indicators
The employment rate is an economic indicator with significance in
multiple areas. The rate of employment, naturally, measures the soundness of
an economy. (See Figure 4.2.) The unemployment rate is a lagging economic
indicator. It is an important feature to remember, especially in times of
economic recession. Whereas people focus on the health and recovery of the
job sector, employment is the last economic indicator to rebound. When
economic contraction causes jobs to be cut, it takes time to generate
psychological confidence in economic recovery at the managerial level before
new positions are added. At individual levels, the improvement of the job
outlook may be clouded when new positions are added in small companies
and thus not fully reflected in the data. The employment reports are
significant to the financial markets in general and to foreign exchange in
particular. In foreign exchange, the data is truly affective in periods of
economic transition—recovery and contraction. The reason for the indicators'
importance in extreme economic situations lies in the picture they paint of the
health of the economy and in the degree of maturity of a business cycle. A
decreasing unemployment figure signals a maturing cycle, whereas the
opposite is true for an increasing unemployment indicator.
FOREX. On-line Manual For Successful Trading 40
Figure 4.2. The U.S. unemployment rate.
Employment Cost Index (ECI)
Employment cost index measures wages and inflation and provides the
most comprehensive analysis of worker compensation, including wages,
salaries, and fringe benefits. The ECI is one of the Fed's favorite quarterly
economic statistics.
Consumer Spending Indicators
Retail sales is a significant consumer spending indicator for foreign
exchange traders, as it shows the strength of consumer demand as well as
consumer confidence. component in the calculation of other economic
indicators, such as GNP and GDP.
Generally, the most commonly used employment figure is not the
monthly unemployment rate, which is released as a percentage, but the
nonfarm payroll rate. The rate figure is calculated as the ratio of the
difference between the total labor force and the employed labor force, divided
by the total labor force. The data is more complex, though, and it generates
more information. In foreign exchange, the standard indicators monitored by
traders are the unemployment rate, manufacturing payrolls, nonfarm payrolls,
average earnings, and average workweek. Generally, the most significant
employment data are manufacturing and nonfarm payrolls, followed by the
unemployment rate.
Auto Sales
Despite the importance of the auto industry in terms of both production
and sales, the level of auto sales is not an economic indicator widely followed
by foreign exchange traders. The American automakers experienced a long,
FOREX. On-line Manual For Successful Trading 41
steady market share loss, only to start rebounding in the early 1990s. But car
manufacturing has become increasingly internationalized, with American cars
being assembled outside the United States and Japanese and German cars
assembled within the United States. Because of their confusing nature, auto
sales figures cannot easily be used in foreign exchange analysis.
Leading Indicators
The leading indicators consist of the following economic indicators:
• average workweek of production workers in manufacturing;
• average weekly claims for state unemployment;
• new orders for consumer goods and materials (adjusted for
inflation);
• vendor performance (companies receiving slower deliveries from
suppliers);
• contracts and orders for plant and equipment (adjusted for
inflation);
• new building permits issued;
• change in manufacturers' unfilled orders, durable goods;
• change in sensitive materials prices.
Personal Income
is the income received by individuals, nonprofit institutions, and private
trust funds. Components of this indicator include wages and salaries, rental
income, dividends, interest earnings, and transfer payments (Social Security,
state unemployment insurance, and veterans' benefits). The wages and
salaries reflect the underlying economic conditions.
This indicator is vital for the sales sector. Without an adequate personal
income and a propensity to purchase, consumer purchases of durable and
nondurable goods are limited.
For the Forex traders, personal income is not significant.
FOREX. On-line Manual For Successful Trading 42
4.3. Financial and Sociopolitical Factors
The Role of Financial Factors
Financial factors are vital to fundamental analysis. Changes in a
government's monetary or fiscal policies are bound to generate changes in
the economy, and these will be reflected in the exchange rates. Financial
factors should be triggered only by economic factors. When governments
focus on different aspects of the economy or have additional international
responsibilities, financial factors may have priority over economic factors. This
was painfully true in the case of the European Monetary System in the early
1990s. The realities of the marketplace revealed the underlying artificiality of
this approach. Using the interest rates independently from the real economic
environment translated into a very expensive strategy.
Because foreign exchange, by definition, consists of simultaneous
transactions in two currencies, then it follows that the market must focus on
two respective interest rates as well. This is the interest rate differential, a
basic factor in the markets. Traders react when the interest rate differential
changes, not simply when the interest rates themselves change. For example,
if all the G-5 countries decided to simultaneously lower their interest rates by
0.5 percent, the move would be neutral for foreign exchange, because the
interest rate differentials would also be neutral.
Of course, most of the time the discount rates are cut unilaterally, a
move that generates changes in both the interest differential and the
exchange rate. Traders approach the interest rates like any other factor,
trading on expectations and facts. For example, if rumor says that a discount
rate will be cut, the respective currency will be sold before the fact. Once the
cut occurs, it is quite possible that the currency will be bought back, or the
other way around. An unexpected change in interest rates is likely to trigger a
sharp currency move. "Buy on the rumor, sell on the fact...".
Other factors affecting the trading decision are the time lag between
the rumor and the fact, the reasons behind the interest rate change, and the
perceived importance of the change. The market generally prices in a
discount rate change that was delayed. Since it is a fait accompli, it is neutral
to the market. If the discount rate was changed for political rather than
economic reasons, what is a common practice in the European Monetary
System, the markets are likely to go against the central banks, sticking to the
real fundamentals rather than the political ones. This happened in both
September 1992 and the summer of 1993, when the European central banks
lost unprecedented amounts of money trying to prop up their currencies,
despite having high interest rates. The market perceived those interest rates
as artificially high and, therefore, aggressively sold the respective currencies.
Finally, traders deal on the perceived importance of a change in the interest
rate differential.
FOREX. On-line Manual For Successful Trading 43
Political Events and Crises
Political events generally take place over a period of time, but political
crises strike suddenly. They are almost always, by definition, unexpected.
Currency traders have a knack for responding to crises. Speed is essential;
shooting from the hip is the only fighting option. The traders' reflexes take
over. Without fast action, traders can be left out in the cold. There is no time
for analysis, and only a split second, at best, to act. As volume drops
dramatically, trading is hindered by a crisis. Prices dry out quickly, and
sometimes the spreads between bid and offer jump from 5 pips to 100 pips.
Getting back to the market is difficult.
FOREX. On-line Manual For Successful Trading 44
CHAPTER 5
Technical Analysis
5.1. The Fundamentals Of Technical Analysis
Technical analysis is appointed to analyze market movement (the
movement of prices, volumes and open interests) using the information
obtained for a past time. Mainly, it is the chart study of past behavior of
currencies prices in order to forecast their future performance. It is one of the
most significant tools available for the forecasting of financial markets. Such
analysis has been an increasingly utilized forecasting tool over the last two
centuries.
The main strength of technical analysis is the flexibility with regard to
the underlying instrument, regarding the markets and regarding the time
frame. A trader who deals several currencies but specializes in one may easily
apply the same technical expertise to trading another currency. A trader who
specializes in spot trading can make a smooth transition to dealing currency
futures by using chart studies, because the same technical principles apply
over and over again, regardless of the market. Finally, different players have
different trading styles, objectives, and time frames.
Technical analysis is easy to compute what is important while the
technical services are becoming increasingly sophisticated and reasonably
priced.
Prior to this historic open market intervention, technical analysis
provided ample selling signals.
Price
The Fundamental Principles of Technical Analysis are based on the Dow
Theory with the following main thesis:
1. The price is a comprehensive reflection of all the market forces. At
any given time, all market information and forces are reflected in the currency
prices.
2. Price movements are historically repetitive.
3. Price movements are trend followers.
FOREX. On-line Manual For Successful Trading 45
4. The market has three trends: primary, secondary, and minor. The
primary trend has three phases: accumulation, run-up/run-down, and
distribution. In the accumulation phase the shrewdest traders enter new
positions. In the run-up/run-down phase, the majority of the market finally
"sees" the move and jumps on the bandwagon. Finally, in the distribution
phase, the keenest traders take their profits and close their positions while
the general trading interest slows down in an overshooting market. The
secondary trend is a correction to the primary trend and may retrace one-
third, one-half or two-thirds from the primary trend.
5. Volume must confirm the trend.
6. Trends exist until their reversals are confirmed. Figure 5.1. shows
example of reversals in a bearish currency market. The buying signals occur
at points A and B when the currency exceeds the previous highs.
Figure 5.1. A reversal of bearish currency
Cycles of currency price change are the propensity for events to repeat
themselves at roughly the same time and are an important ground to justify
the Dow Theory.
Cycle identification is a powerful tool that can be used in both the long
and the short term. The longer the term, the more significance a cycle has.
Figure 5.2. shows a series of three cycles. The top of the cycle (C) is called
the crest and the bottom (T) is known as trough. Analysts measure cycles
from trough to trough.
Cycles are gauged in terms of amplitude, period, and phase. The
amplitude shows the height of the cycle, the period shows the length of the
cycle, the phase shows the location of a wave trough.
FOREX. On-line Manual For Successful Trading 46
Figure 5.2. The structure of cycles
Figure 5.3. The two gauging measures of a cycle: period and phase.
Volume and Open Interest
Volume consists of the total amount of currency traded within a period
of time, usually one day. For example, by year 2000, the total foreign
currency daily trading volume was $1.4 trillion. But traders are naturally more
interested in the volume of specific instruments for specific trading periods,
because large trading volume suggests that there is interest and liquidity in a
certain market, and low volume warns the trader to veer away from that
market.
The risks of a low-volume market are usually very difficult to quantify or
hedge. In addition, certain chart formations require heavy trading volume for
successful development. An example is the head-and-shoulder formation.
Therefore, despite its obvious importance, volume is not easy to quantify in
all foreign exchange markets.
One method to estimate volume is to extrapolate the figures from the
futures market. Another is "feeling" the size of volume based on the number
FOREX. On-line Manual For Successful Trading 47
of calls on the dealing systems or phones, and the "noise" from the brokers'
market.
Open interest is the total exposure, or outstanding position, in a certain
instrument. The same problems that affect volume are also present here. As
it was already mentioned, figures for volume and open interest are available
for currency futures. If you have access to printed or electronic charts on
futures, you will be able to see these numbers plotted at the bottom of the
futures charts.
Volume and open interest figures are available from different sources,
although one day late such as the newswires (Bridge Information Systems,
Reuters, Bloomberg), newspapers (the Wall Street Journal, the Journal of
Commerce), Weekly printed charts (Commodity Perspective, Commodity
Trend Service).
FOREX. On-line Manual For Successful Trading 48
5.2. Types of charts
Line Chart
The line chart is the original type of chart. In order to plot it, a line
connects single prices for a selected time period. The most popular line chart
is the daily chart. Although any point in the day can be plotted, most traders
focus on the closing price, which they perceive as the most important. (See
Figure 5.4.) But an immediate problem with the daily line chart is the fact that
it is impossible to see the price activity for the balance of the day.
Figure 5.4. An example of the line chart
Line charts are considered for technical analysis because due to the
sophistication of current charting services, daily price activity does not need
to be lost.
Daily line charts are useful when looking for the big picture or the major
trend because, without line charts, intraday activity would be-come an
unimportant detail. When plotted over a long stretch of time, such as several
years, a line chart is easier to visualize. Also, technical analysis goes well
beyond chart formation; in order to execute certain models and techniques,
line charts are better suited than any of the other charts.
FOREX. On-line Manual For Successful Trading 49
However the line chart is a continuous chart, and this is a disadvantage
because price gaps cannot be charted on a continuous chart.
Bar Chart
The bar chart is arguably the most popular type of chart currently in
use. It consists of four significant points (See figure 5.5.):
• the high and the low prices, which are united by a vertical bar;
• the opening price, which is marked with a little horizontal line to the
left of the bar;
• the closing price, which is marked with a little horizontal line to the
right of the bar.
Figure 5.5. An example of the bar chart.
The opening price is not always important for analysis.
Bar charts have the obvious advantage of displaying the currency range
for the period selected. The most popular period is daily, followed by weekly.
Other periods may be selected as well. An advantage of this chart is that,
unlike line charts, the bar chart is able to plot price gaps that are formed in
the currency futures market. Although the currency futures market trades
around the clock, physically it is open for only about a third of the trading
FOREX. On-line Manual For Successful Trading 50
day. (Chicago IMM is open for business 7:20 am to 2 pm CDT.) Therefore,
price gaps may occur between two days' price ranges. Incidentally, the bar
chart is the chart of choice among currency futures traders.
Candlestick Chart
The candlestick chart is closely related to the bar chart. It also consists
of four major prices: high, low, open, and close. (See Figure 5.6.) In addition
to the common readings, the candlestick chart has a set of particular
interpretations. It is also easier to view.
.
Figure 5.6. An example of the candlestick chart
The opening and closing prices form the body (jittai) of the candlestick.
To indicate that the opening was lower than the closing, the body of the bar
is left blank. In its original form, the body was colored red. Current standard
electronic displays allow you to keep it blank or select a color of your choice.
If the currency closes below its opening, the body is filled. In its original form,
the body was colored black, but the electronic displays allow you to keep it
filled or to select a color of your choice.
FOREX. On-line Manual For Successful Trading 51
The intraday (or weekly) direction on a candlestick chart can be traced
by means of two "shadows": the upper shadow (uwakage) and the lower
shadow (shitakage).
Just as with a bar chart, the candlestick chart is unable to trace every
price movement during a day's activity.
FOREX. On-line Manual For Successful Trading 52
5.3. Trends, Support and Resistance
Kinds Of Trends
The trend shows a pending direction of the market movement.
A trend may be:
1. Upward (See Figure 5.7.)
2. Downward (See Figure 5.8.)
3. Sideways, also known as a "flat market" or "trendless" (See Figure
5.9.)
Because the markets do not move in a straight line in any direction, but
rather in zigzags, it is the direction of these peaks and troughs that creates
the market trend. In addition to direction, trends are also classified by time
frame: major or long-term trends, secondary or medium-term trends, and
near-term or short-term trends. Any number of secondary and near-term
trends may occur within a major trend. The time frames for each class vary
widely. The Dow Theory suggests a one-year length for a major trend.
Currently, for a major trend, the market expects a time span of over one
year. Secondary trends should last for a matter of months, and short-term
trends for a matter of weeks.
Figure 5.7. An example of the up trend
FOREX. On-line Manual For Successful Trading 53
Figure 5.8. An example of the down trend
Figure 5.9. An example of the sideways trend
FOREX. On-line Manual For Successful Trading 54
Percentage Retracement
Foreign currencies, like all the other financial instruments, do not move
straight up or down, even in the healthiest of trends. Traders watch several
percentage retracements, in search of price objectives.
There are three typical percentage retracements:
1. Charles Dow developed the traditional percentage retracements
which are 1/3, 1/2, and 2/3; or 33 percent, 50 percent, and 66 percent. A
retracement past 66 percent is considered to be a trend failure.
2. The Fibonacci ratios. These ratios are 0.382, 0.50, and 0.618, or
approximately 38 percent, 50 percent, and 62 percent.
3. The Gann percentages attach importance to the one-eighth break-
downs.
The Trendline
A trendline is the natural development in tracking a trend. It simply
consists of a straight line connecting the significant highs (peaks) or the
significant lows (troughs.) Following in the tracks of the trend directions, the
trendlines may be classified as:
1. Rising trendlines. (See Figure 5.10.)
2. Declining trendlines. (See Figure 5.11.)
3. Sideways trendlines. (See Figure 5.12.)
To draw a trendline only two points are necessary and the third one is
the contact point confirmation. The currency maintains its general direction
and velocity. A trendline exists until it is broken as a result of a significal move
of the price up or down. Hence, even after confirmation, the breakout is still
likely to be followed by a period of consolidation It is relatively rare for a
trendline to suddenly reverse its direction. If a consolidation period does
indeed occur, the longer it lasts, the steeper the following rally will be.
Breakouts from up trendlines tend to test the strength of the former support
line, now turned into a resistance line.
A price filter of 3 percents serves usually to test the validity of the
breakout.
FOREX. On-line Manual For Successful Trading 55
Figure 5.10. Example of a rising trendline.
Figure 5.11. An example of the declining trendline.
FOREX. On-line Manual For Successful Trading 56
Figure 5.12. An example of the sideways trendline
The trendline and a line drawn along the opposite edge of the trend
pattern about to be parallel to the trendline form the trade channel (See
Figure 5.13.). Then the both lines are known as the channel lines.
Lines of Support and Resistance
The upper and bottom borders of a trade channel (See Figure 5.14.)
forme lines of support and resistance. The peaks represent the price levels at
which the selling pressure exceeds the buying pressure are known as
resistance levels. The troughs, on the other hand, represent the levels at
which the selling pressure succumbs to the buying pressure. They are called
support levels. The longer the prices bounce off the support and resistance
levels, the more significant the trend becomes. Trading volume is also very
important, especially at the critical support and resistance levels. When the
currency bounces off these levels under heavy volume, the significance of the
trend increases. The importance of support and resistance levels goes beyond
their original functions. If these levels are convincingly penetrated, they tend
to turn into just the opposite. A firm support level, once it is penetrated on
heavy volume, will likely turn into a strong resistance level. Conversely, a
strong resistance turns into a firm support after being penetrated.
FOREX. On-line Manual For Successful Trading 57
Figure 5.13. An example of the trade channel
Figure 5.14. Example of the support turned into resistance
FOREX. On-line Manual For Successful Trading 58
5.4. Trend Reversal Patterns
Chart formations are generally sorted on the basis of their significance
to the current trend of the underlying currency. Formations signaling the end
of the trend are known as reversal patterns. Conversely, chart formations that
confirm that the underlying currency trend is intact are called continuation
patterns.
The most significant trend reversal patterns are:
1. Head-and-shoulders and inverse head-and-shoulders.
2. Double tops and double bottoms.
3. Triple tops and triple bottoms.
Head-And-Shoulders
The head-and-shoulders pattern is one of the most reliable and well-
known chart formations. It consists of three consecutive rallies. The first and
third rallies—the shoulders—have about the same height, and the middle
one—the head—is the highest. All three rallies are based on the same support
line (or on the resistance line in the case of the reversed head-and-shoulders
formation), known as the neckline.
Prior to point A, the neckline was a resistance line (see Figure 5.15.).
Once the resistance line was broken, it turned into a significant support line.
The price bounced off it twice, at points B and C. The neckline was eventually
broken in point D, under heavy volume, and the trend reversal was
confirmed. As the significant support line was broken, a retracement could be
expected to retest the neckline (E), now a resistance line again. If the
resistance line held, the price was expected to eventually decline to around
level F, which was the price target of the head-and-shoulders formation. The
target was approximately equal in amplitude to the distance between the top
of the head and the neckline. The price target was measured from point D,
where the neckline was broken. (See the dotted lines).
Signals Generated by the Head-and-shoulders Pattern
The head-and-shoulders formation provides excellent information:
1. The support line. This is based on points B and C.
2. The resistance line. After giving in at point D, the market may
retest the neckline at point E.
3. The price direction. If the neckline holds the buying pressure at
point E, then the formation provides information regarding the price direction:
diametrically opposed to the direction of the head-and-shoulders (bearish).
4. The price target. This is provided by the confirmation of the
formation (by breaking through the neckline under heavy trading volume).
FOREX. On-line Manual For Successful Trading 59
Figure 5.15. Diagram of a typical head-and-shoulders pattern
One of the main requirements of the successful development of this
formation is that the breakout through the neckline occurs under heavy
market volume. A breakout on light volume is a strong warning that it is a
false breakout and will trigger a sharp backlash in the currency price. The
time frame for this chart formation's evolution is anywhere from several
weeks to several months. The intraday chart formations are not reliable. The
longer the formation time is, the more significance should be attached to this
pattern. The target is unlikely to be reached in a very short time frame.
Whereas there is no immediate suggestion regarding the length of target
reaching time, common sense would link it to the duration of development of
the chart pattern.
It is reasonable to emphasize the importance of measuring the target
from the point where the neckline was broken. There is a tendency among
new technicians to measure the target price not only from under the neckline
but also from the middle of the formation. This may happen as they measure
the height of the head. Most head-and-shoulders formations, of course, look
different from that in Figure 5.16. Prices fluctuate enough to forego any
possibility of a clean-looking chart line. Also, the neckline is seldom a perfectly
horizontal line.
FOREX. On-line Manual For Successful Trading 60
Figure 5.16. Diagram of a typical inverse head-and-shoulders pattern
Inverse Head-And-Shoulders
The inverse head-and-shoulders formation is a mirror image of the
previous pattern. Therefore, you can apply the same characteristics, potential
problems, signals, and trader's point of view from the preceding presentation.
The underlying currency broke out of the downtrend ranged by the xx'-yy'
channel. The currency retested the previous resistance line (the rally number
3), now turned into a support line. Among the three consecutive rallies, the
shoulders (1 and 3) have approximately the same height, and the head is the
lowest. Prior to point A, the neckline was a support line. Once this line was
broken, it turned into a significant resistance line. The price bounced off the
neckline twice, at points В and C. The neckline was eventually broken at point
D, under heavy volume. As the significant resistance line was broken, a
retracement could be expected to retest the neckline (E), now a support line
again. If it held, the price was expected to eventually rise to around level F,
which is the price target of the head-and-shoulders formation.
The price objective is approximately equal in amplitude to the distance
between the top of the head and the neckline, and is measured from the
breakout point D.
Double Top
Another very reliable and common trend reversal chart formation is the
double top. As the name clearly and succinctly describes, this pattern consists
of two tops (peaks) of approximately equal heights. (See Figure 5.17.). A
parallel line is drawn against a resistance line that connects the two tops. We
should think of this line as identical to the head-and-shoulders' neckline. As a
resistance line, it is broken at point A. It turns into a strong support for price
FOREX. On-line Manual For Successful Trading 61
level at C, but eventually fails at point E. The support line turns into a strong
resistance line, which holds the market backlash at point F. The price
objective is at level G, which is the average height of the double top
formation, measured from point E.
Figure 5.17. Diagram of a typical double-top formation
Signals Provided by the Double Top Formation
The double top formation provides information on:
1. The support line, set between points A and E.
2. The resistance line, set between points В and D.
3. The price direction. If the neckline holds the buying pressure at
point F, then the formation provides information regarding the price direction:
diametrically opposed to the direction of the peaks (bearish).
4. The price target, provided by the confirmation of the formation (by
breaking through the neckline under heavy trading volume).
Exactly as in the case of the head-and-shoulders pattern, a vital
requirement for the successful completion of the double-top formation is that
the breakout through the neckline occurs under heavy market volume. Again,
please remember that gauging volume in traditional ways is only possible in
the currency futures market. Therefore, the trader must estimate the size of
the cash market volume by extrapolating from
The currency futures' volume and the trading "noise." A breakout on
light volume is a strong case for a false breakout, which would trigger a sharp
backlash in the currency price. The time frame for this chart formation's
evolution is anywhere from several weeks to several months. The intraday
chart formations are less reliable. There is a strong correlation between the
length of time to develop the pattern and the significance of the formation.
FOREX. On-line Manual For Successful Trading 62
The target is unlikely to be reached in a very short time frame. There is
no direct suggestion regarding the length of target reaching time; but foreign
exchange common sense links it to the duration of development.
It is important to measure the target from the point where the neckline
was broken. Avoid the trap of measuring the target price from the middle of
the formation under the neckline. This may happen as you measure the
average height of the formation.
Double Bottom
The double bottom formation is a mirror image of the previous pattern.
(See Figure 5.18.). Therefore, one may apply the same characteristics,
potential problems, signals, and trader's point of view from the preceding
presentation.
Figure 5.18. Diagram of a typical double-bottom formation
The bottoms have about the same amplitude. A parallel line (the
neckline) is drawn against the line connecting the two bottoms (B and D.) As
a support line, it is broken at point A. It turns into a strong resistance for
price level at C, but eventually fails at point E. The resistance line turns into a
strong support line, which holds the market backlash at point F. The price
objective is at level G, which is the average height of the bottoms, measured
from point E. (See the dotted lines).
Triple Top And Triple Bottom
The triple top is a hybrid of the head-and-shoulders and double-top
trend reversal formations. (See Figure 5.19.) Conversely, the triple bottom is
a hybrid of the inverse head-and-shoulders and double-bottom formations.
(See Figure 5.20.) Consequently, they have the same characteristics, potential
FOREX. On-line Manual For Successful Trading 63
problems, signals, and trader's point of view as the double top or double
bottom, respectively.
As shown in Figure 5.19., in a typical triple-top formation, the tops have
about the same height. A parallel line (the neckline) is drawn against the line
connecting the three tops (B, D, and F.) As a resistance line, the neckline is
broken at point A. It turns into a strong support for price levels at С and E,
but eventually fails at point G. The support line turns into a strong resistance
line, which holds the market backlash at point H. The price objective is at
level I, which is the average height of the three tops formation, as measured
from point D (see the dotted lines).
Figure 5.19. Diagram of a triple-top formation
As a double top, the formation fails at point E. The price moves up
steeply toward point F. The resistance line is holding once more and the price
drops sharply again toward point G. At this level, the market pressure is able
to penetrate the support line. After a possible retest of the neckline, the
prices drop further, to eventually reach the price objective.
The opposite is true for the triple bottom
As shown in Figure 5.19., in a triple-bottom formation, the bottoms
have about the same amplitude. A parallel line (the neckline) is drawn against
the line connecting the three bottoms (B, D, and F.) As a support line, the
neckline is broken at point A. It turns into a strong resistance for price levels
at С and E, but eventually fails at point G. The resistance line turns into a
strong support line, which holds the market backlash at point H. The price
objective is at level I, which is the average length of the triple-bottom
formation, as measured from point D (see the dotted lines).
FOREX. On-line Manual For Successful Trading 64
Figure 5.20. Diagram of a typical triple-bottom formation.
Rounded Top and Bottom Formations
The rounded top and bottom, also known as saucers consist of a very
slow and gradual change in the direction of the market. These patterns reflect
the indecision of the market at the end of a trend. The trading activity is slow.
It is impossible to know when the formation is indeed completed, and not for
a lack of trying. Like any other consolidation pattern, the longer it takes to
complete, the higher the likelihood of a sharp price move in the new
direction.
Diamond Formation
The diamond formation tends to occur at the top of the trend. The price
activity may be outlined by a shape resembling a diamond (see Figure 5.21.).
The increase and decrease in trading volume closely mimic the combination of
divergent and convergent support and resistance lines. Upon breakout,
volume picks up substantially. The price target is the height of the diamond,
measured from the breakout point.
The head-and-shoulders, the double top and bottom and the triple top
and bottom, due to their significance in trend reversals, are generally known
as major reversal patterns.
FOREX. On-line Manual For Successful Trading 65
Figure 5.21. A scheme of a diamond reversal formation
FOREX. On-line Manual For Successful Trading 66
5.5. Trend Continuation Patterns
Technical analysis provides charts that reinforce the current trends.
These chart formations are known as continuation patterns. They consist of
fairly short consolidation periods. The breakouts occur in the same direction
as the original trend.
The most important continuation patterns are:
1. Flags
2. Pennants
3. Triangles
4. Wedges
5. Rectangles
Flag formation
The flag formation provides signals for direction and price objective.
This formation represents a brief consolidation period within a solid and steep
upward or downward trend. The consolidation itself is bordered by a support
line and a resistance line, which are parallel to each other or very mildly
converging, making it look like a flag (parallelogram) and tends to be sloped
in the opposite direction from the slope of the original trend, or is simply flat.
The previous sharp trend is resembles a flagpole.
If the original trend is going down, the formation is called a bearish
flag. (See Figure 5.22.) As Figure 5.22. shows, the original trend is sharply
down. The flagpole is measured between points A and B. The consolidation
period occurs between the support line B to E and the resistance line C to D.
When the price penetrates the support line at point E, the trend resumes its
fall, with the price objective F, measured from E. The price target is of about
equal amplitude with the flagpole's length (A to B), measured from the
breakout point through the support line (B to E.)
In the numerical example, the height of the flagpole is measured as the
difference between 140.00 and 120.00 equals 2000 pips. Once the support
line is broken at 125.00, the price target is 105.00, as 2000 pips from 125.00.
Pennant Formation
The pennants are closely related to the flags. The same principles apply.
The sole difference is that the consolidation area better resembles a pennant, as
the support and resistance lines converge. If the original trend is bullish, then
the chart pattern is a bullish pennant. In Figure 5.23., the pennant pole is A to B
The pennant-shaped consolidation is framed by C, B, and D. When the market
breaks through the resistance line B to D, the price objective is E. The
amplitude of the target price is D to E, and it is equal to the pennant pole A to B.
The price target measurement starts from the breakout point.
FOREX. On-line Manual For Successful Trading 67
Figure 5.22. Diagram of a bear flag formation
In the numerical example, the height of the pennant pole is measured as
the difference between 1.5500 and 1.4500, or 1000 pips. Once the resistance line
is broken at 1.5200, the price target is 1.6200, as 1000 pips from 1.5200.
Figure 5.23. Diagram of a bullish pennant.
FOREX. On-line Manual For Successful Trading 68
If the original trend is going down, then the formation is a bearish
pennant. In Figure 5.24., the pennant pole is A to B. The pennant-shaped
consolidation is framed by C, B and D. When the market breaks through the
support line B to D, the objective price is E. The amplitude of the target price is D
to E, and it is equal to the pennant pole A to B. The price target measurement
starts from the breakout point.
In the numerical example, the height of the flagpole is measured as the
difference between 139.00 and 119.00, or 2000 pips. Once the support line is
broken at 120.00, the price target is 100.00, as 2000 pips from 120.00.
Figure 5.24. Diagram of a bearish pennant
FOREX. On-line Manual For Successful Trading 69
Triangle Formation
Triangles can be visualized as pennants with no poles. There are four
types of triangles: symmetrical, ascending, descending, and expanding
(broadening).
A symmetrical triangle consists of two symmetrically converging support
and resistance lines, defined by at least four significant points. (See Figure 5.25.)
The two symmetrically converging lines suggest that there is a balance between
supply and demand in the foreign exchange market. Consequently, a break
may occur on either side. In the case of a bullish symmetrical triangle, the
breakout will occur in the same direction, qualifying the formation as a
continuation pattern.
Figure 5.25. A market example of a bearish pennant
FOREX. On-line Manual For Successful Trading 70
As Figure 5.26. shows, the converging lines are symmetrical. The declining
line is defined by points B, D, and F. The rising support line is defined by points
A, C, E, and G. The price target is either (1) equal to the width of the base of
the triangle BB', measured from the breakout point H (HH'); or (2) at the
intersection of line BI (which is a parallel line to the rising line AG) with the price
line.
Trading volume will visibly decrease toward the end of the triangle,
suggesting the ambivalence of the market. The breakout is accompanied by a rise
in volume.
In the numerical example, the price objective is either 1.5500, as the
difference between 1.5000 and 1.4000, measured from 1.4500 or 1.5300, as the
difference between 1.5000 and 1.4000, measured from 1.4300.
Figure 5.26. Diagram of a bullish symmetrical triangle
FOREX. On-line Manual For Successful Trading 71
The ascending triangle consists of flat resistance line and a rising support
line. (See Figure 5.27.) The formation suggests that demand is stronger than
supply. The breakout should occur on the upside, and it consists of the width of
the base of the triangle as measured from the breakout point. As you can see in
Figure 5.28., the resistance line defined by points A, C, and E is flat. The
converging bottom line, defined by points B, D, and F, is sloped upward. The price
objective is the with of the base of the triangle (AA') measured above the
resistance line from the breakout point G (GG'.) In the numerical example, the
price objective is 106.00, as the 200-pip difference between 105.00 and 103.00,
measured from 104.00.
Trading volume is decreasing steadily toward the tip of the triangle, but
increases rapidly on the breakout.
Figure 5.27. An example of a symmetrical triangle
FOREX. On-line Manual For Successful Trading 72
Figure 5.28. Diagram of typical ascending triangle
The descending triangle is simply a mirror image of the ascending triangle. It
consists of a flat support line and a downward sloping resistance line. (See
Figure 5.29.) This pattern suggests that supply is larger than demand. The
currency is expected to break on the downside. The descending triangle also
provides a price objective. This objective is calculated by measuring the width
of the triangle base and then transposing it to the breakpoint. As shown in
Figure 5.29., the support line, defined by points A, C, E, and G, is flat. The
converging top line, defined by points B, D, F, and H, is sloped downward. The
price objective is the width of the base of the triangle (AA'), measured above
the support line from the breakout point I (IF.)
In the numerical example, the price objective is 1.3000, as the 1000-pip
difference between 1.5000 and 1.4000, measured from 1.4000.
FOREX. On-line Manual For Successful Trading 73
Figure 5.29. Diagram of a descending triangle
Trading volume is decreasing steadily toward the tip of the triangle, but
increases rapidly on the breakout.
The expanding (broadening) triangle consists of a horizontal mirror image of
a triangle, where the tip of the triangle is next to the original trend, rather than its
base. (See Figure 5.30.) Volume also follows the horizontal mirror image switch
and increases steadily as the chart formation develops. As shown in Figure 5.30,
the bottom support line, defined by points B, D, and F, and the top line, defined by
points A, C, and E, are divergent. The price objective should be the width, GG', of
the base of the triangle, measured from the breakout point G.
In the numerical example, the price objective is 102.00, as the 100-pip
difference between 101.00 and 100.00, measured from 101.00.
FOREX. On-line Manual For Successful Trading 74
Figure 5.30. Diagram of an expanding triangle
Wedge Formation
The wedge formation is a close relative of the triangle and the pennant
formations. It resembles both the shape and the development time of the
triangles, but it really looks and behaves like a pennant without a pole. The
wedge is markedly sloped, and the breakout occurs in the direction opposite to its
slope (see Figure 5.31.), but similar to the direction of the original trend. The
signal we receive from the wedge formation is direction only. There is no reliable
price objective. Depending on the trend direction, there are two types of
wedges: falling (see Figure 5.31.) and rising.
FOREX. On-line Manual For Successful Trading 75
Figure 5.31. Diagram of a falling wedge
Rectangle Formation
Also known as a trading range (or congestion), the rectangle formation
reflects a consolidation period. Upon breakout, it is likely to continue the
original trend. Its failure will change it from a continuation to a reversal pattern.
This pattern is easy to spot, as it can be considered a minor side-ways trend.
If it occurs within an uptrend and the breakout occurs on the upside, it is
called a bullish rectangle. (See Figure 5.32.) The price objective is the height of
the rectangle. As Figure 5.32. shows, the currency moves between well-
defined, flat support and resistance levels. A valid breakout may occur on
either side from this consolidation period. The price target (GH) is equal to the
height of the rectangle (G'H), measured from the breakout point H. In the
numerical example, the price objective is 1.6200, as the 100-pip difference
between 1.6100 and 1.6000, measured from 1.6100.
If the consolidation occurs within a downtrend and the breakout continues
the original trend, then it is called a bearish rectangle. (See Figure 5.33.) As
shown in Figure 5.33., the currency moves between well-defined, flat support
and resistance levels. A valid breakout may occur on either side of this
consolidation period. The price objective (HG') is equal in size to the height of the
rectangle (GH), measured from the breakout point H. In the numerical example,
the price objective is 100.00, as the 100-pip difference between 102.00 and
101.00, measured from 101.00.
FOREX. On-line Manual For Successful Trading 76
Figure 5.32. Diagram of a typical bullish rectangle
Figure 5.33. Diagram of a typical bearish rectangle
FOREX. On-line Manual For Successful Trading 77
5.6. Gaps
An opening outside the previous day's or other period's range generates
a price gap.
Price gaps, as plotted on bar charts, are very common in the currency
futures market. Although currency futures may be traded around the clock,
their markets are open for only about a third of the trading day. For instance,
the largest currency futures market in the world, the Chicago IMM, is open for
business 7:20 am to 2:00 pm CDT. Since the cash market continues to trade
around the clock, price gaps may occur between two days' price ranges in the
futures market.
There are four types of gaps: common, breakaway, runaway, and
exhaustion.
Common Gaps
Common gaps have the least technical significance of all the types of
gaps. They do not indicate a trend start, continuation, reversal, or even a
general direction of the currency other than in the very short term. Common
gaps tend to occur in relatively quiet periods or in illiquid markets. When price
gaps occur in illiquid markets, such as distant currency futures expiration
dates, they must be completely ignored. The entries for distant expiration
dates in currency futures are made only on a closing basis, and they do not
reflect any trading activity. Never trade in an illiquid market because getting
out of it is very difficult and expensive. When gaps occur within regular
trading ranges, the word on the street has been that, "Gaps must be filled.".
Common gaps are short term. When currency futures open higher than
yesterday's high, they are quickly sold, targeting the level of the previous
day's high.
Breakaway Gaps
Breakaway gaps occur at the beginning of a new trend, usually at the
end of long consolidation periods. They may also appear after the completion
of some chart formations that tend to act as short-term consolidations.
Breakaway gaps signify a brisk change in trading sentiment, and they occur
on increasingly heavy trading. Traders are understandably frustrated by
consolidations, which are rarely profitable. Therefore, a breakout from the
slow lane is embraced with optimism by the profit-hungry traders. The price
takes a secondary place to participation. As always, naysayers follow the
initial breakout. Sooner rather than later, the pessimists have no choice but to
join the new move, thus creating more volume.
Breakaway gaps are not likely to be filled during the breakout and for
the duration of the subsequent move. In time, they may be filled during a
new move on the opposite side.
FOREX. On-line Manual For Successful Trading 78
In Figure 5.34., the currency futures trades sideways in a 100-pip range
between 0.6550 and 0.6690 for a period of time. A price gap between 0.6690
and 0.6730 signals the breakaway from the range.
Figure 5.34. A typical breakaway gap.
Signals for Breakaway Gaps:
1. A breakaway gap provides the price direction.
2. There is no price objective.
3. Increasing demand for a currency ensures a solid move on good
volume in the foreseeable future.
Runaway Gaps
From a technical point of view, runaway, or measurement, gaps are
special gaps that occur within solid trends. They are known as measurement
gaps because they tend to occur about midway through the life of a trend.
Thus, if you measure the total range of the previous trend and extrapolate it
from the measurement gap, you can identify the end of the trend and your
price objective. Since the velocity of the move should be similar on both sides
of the gap, you also have a time frame for the duration of the trend.
Trading Signals for Runaway Gaps
1. The runaway, or measurement, gap provides the direction of the
market. As a continuation pattern, this type of gap confirms the health and
the velocity of the trend.
2. Volume is good because traders like trends, and confirmed trends
attract more optimism and capital.
FOREX. On-line Manual For Successful Trading 79
3. This is the only type of gap that also provides a price objective and a
time frame. These characteristics are also useful for developing hedging
strategies.
Exhaustion Gaps
Exhaustion gaps may occur at the top or bottom of a formation when
trends change direction in an atypically quick manner. There is no
consolidation next to the broken trend line: The trend reversal is very sharp
through a bullish move, looks a lot like a measurement gap. So traders buy
the currency and stay long overnight on that assumption. The following day
the market opens below the previous low, generating a second gap. If the
second gap is filled or does not even occur, the trading signal remains the
same. Traders do not have to get caught badly in this exhaustion gap. A
sudden trend reversal is unlikely to occur in an information void. Some sort of
identifiable event triggers the move—maybe a government fall or a massive
and well-timed central bank intervention. Therefore, traders should at least
be warned.
FOREX. On-line Manual For Successful Trading 80
5.7. Mathematical Trading Methods (Indicators)
The mathematical trading methods provide a more objective view of
price activity. In addition, these methods tend to provide signals prior to their
occurrence on the currency charts. The tools of the mathematical methods
are moving averages and oscillators.
Moving Averages
A moving average is an average of a predetermined number of prices
over a number of days, divided by the number of entries. The higher the
number of days in the average, the smoother the line is. A moving average
makes it easier to visualize currency activity without daily statistical noise. It
is a common tool in technical analysis and is used either by itself or as an
oscillator.
As one can see from Figure 5.35., a moving average has a smoother
line than the underlying currency. The daily closing price is commonly
included in the moving averages. The average may also be based on the
midrange level or on a daily average of the high, low, and closing prices.
Figure 5.35. Examples of three simple moving averages—5-day (white), 20-day (red) and 60-day
(green)
It is important to observe that the moving average is a follower rather
than a leader. Its signals occur after the new movement has started, not before.
FOREX. On-line Manual For Successful Trading 81
There are three types of moving averages:
1. The simple moving average or arithmetic mean.
2. The linearly weighted moving average.
3. The exponentially smoothed moving average.
As described, the simple moving average or arithmetic mean is the
average of a predetermined number of prices over a number of days, divided
by the number of entries.
Traders have the option of using a linearly weighted moving average
(See Figure 5.36.). This type of average assigns more weight to the more
recent closings. This is achieved by multiplying the last day's price by one,
and each closer day by an increasing consecutive number. In our previous
example, the fourth day's price is multiplied by 1, the third by 2, the second
by 3, and the last one by 4; then the fourth day's price is deducted. The new
sum is divided by 9, which is the sum of its multipliers.
Figure 5.36. Example of a 20-day simple moving average (red) as compared to a 20-day
weighted moving average (white)
The most sophisticated moving average available is the exponentially
smoothed moving average. (See Figure 5.37.) In addition to assigning
different weights to the previous prices, the exponentially smoothed moving
average also takes into account the previous price information of the
underlying currency.
FOREX. On-line Manual For Successful Trading 82
Figure 5.37. Example of a 20-day simple moving average (red) as compared to a 20-day
exponential moving average (white)
Trading Signals of Moving Averages
Single moving averages are frequently used as price and time filters. As
a price filter, a short-term moving average has to be cleared by the currency
closing price, the entire daily range, or a certain percentage (chosen at the
discretion of the trader).
The envelope model (See Figure 5.38.) serves as a price filter. It
consists of a short-term (perhaps 5-day) closing price based moving average
to which a small percentage (2 percent is suggested for foreign currencies.)
are added and substracted. The two winding parallel lines above and below
the moving average will create a band bordering most price fluctuations.
When the upper band is penetrated, a selling signal occurs. When the lower
band is penetrated, a buying signal occurs. Because the signals generated by
the envelope model are very short-term and they occur many times against
the ongoing direction of the market, speed of execution is paramount. The
high-low band is set up the same way, except that the moving average is
based on the high and low prices. As a time filter, a short number of days
may be used to avoid any false signals.
FOREX. On-line Manual For Successful Trading 83
Figure 5.38. An envelope model define the edges of the band. A close above the upper
band sends a buying signal and one below the lower band gives a selling signal
Usually traders choose a number of averages to use with a currency. A
suggested number is three, as more signals may be available. It may be
helpful to use intervals that better encompass short-term, medium-term, and
long-term periods, to arrive at a more complex set of signals. Some of the
more popular periods are 4, 9, and 18 days; 5, 20, and 60 days; and 7, 21,
and 90 days. Unless you focus on a specific combination of moving averages
(for instance, 4, 9, and 18 days), the exact number of days for each of the
averages is less important, as long as they are spaced far enough apart from
each other to avoid insignificant signals.
A buying signal on a two-moving average combination occurs when the
shorter term of two consecutive averages intersects the longer one upward. A
selling signal occurs when the reverse happens, and the longer of two
consecutive averages intersects the shorter one downward. (See Figure 5.39.)
Oscillators
Oscillators are designed to provide signals regarding overbought and
oversold conditions. Their signals are mostly useful at the extremes of their scales
and are triggered when a divergence occurs between the price of the underlying
currency and the oscillator. Crossing the zero line, when applicable, usually
generates direction signals. Examples of the major types of oscillators are moving
FOREX. On-line Manual For Successful Trading 84
averages convergence-divergence (MACD), momentum and relative strength
index (RSI).
Figure 5.39. Examples of a sell signal (first and third crossovers) and a buy signals (second
crossover) provided by the 5-day (red) and 20-day (white) moving averages
Stochastics
Stochastics generate trading signals before they appear in the price
itself. Its concept is based on observations that, as the market gets high, the
closing prices tend to approach the daily highs; whereas in a bottoming market,
the closing prices tend to draw near the daily lows.
The oscillator consists of two lines called %K and %D. Visualize %K as the
plotted instrument, and %D as its moving average.
The formulas for calculating the stochastics are:
%K = [(CCL -L9)I(H9 - L9)] * 100, where
CCL = current closing price
L9 - the lowest low of the past 9 days
H9 - the highest high of the past 9 days
and
%D=(H3/L3~) * 100,
where H3 = the three-day sum of (CCL - L9)
L3 = the three-day sum of (H9 - L9)
FOREX. On-line Manual For Successful Trading 85
The resulting lines are plotted on a 1 to 100 scale, with overbought and
oversold warning signals at 70 percent and 30 percent, respectively. The buying
(bullish reversal) signals occur under 10 percent, and conversely the selling
(bearish reversal) signals come into play above 90 percent after the currency
turns. (See Figure 5.40.) In addition to these signals, the oscillator-currency price
divergence generates significant signals.
Figure 5.40. An example of the stochastic
The intersection of the %D and %K lines generates further trading signals.
There are two types of intersections between the %D and %K lines:
1. The left crossing, when the %K line crosses prior to the peak of the
%D line.
2. The right crossing, when the %K line occurs after the peak of the %D
line.
Moving Average Convergence-Divergence (MACD)
The moving average convergence-divergence (MACD) oscillator,
developed by Gerald Appel, is built on exponentially smoothed moving aver
ages. The MACD consists of two exponential moving averages that are plotted
against the zero line. The zero line represents the times the values of the two
moving averages are identical.
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In addition to the signals generated by the averages' intersection with
the zero line and by divergence, additional signals occur as the shorter
average line intersects the longer average line. The buying signal is displayed
by an upward crossover, and the selling signal by a downward crossover.
(See Figure 5.41.)
Figure 5.41. An example of MACD
Momentum
Momentum is an oscillator designed to measure the rate of price
change, not the actual price level. This oscillator consists of the net difference
between the current closing price and the oldest closing price from a
predetermined period.
The formula for calculating the momentum (M) is:
M=CCP-OCP, where
CCP - current closing price
OCP - old closing price for the predetermined period.
The new values thus obtained will be either positive or negative
numbers, and they will be plotted around the zero line. At extreme positive
values, momentum suggests an overbought condition, whereas at extreme
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negative values, the indication is an oversold condition. (See Figure 5.42.)
The momentum is measured on an open scale around the zero line.
Figure 5.42. An example of the momentum oscillator
This may create potential problems when a trader must figure out
exactly what an extreme overbought or oversold condition means. On the
simplest level, the relativity of the situation may be addressed by analyzing
the previous historical data and determining the approximate levels that
delineate the extremes. The shorter the number of days included in the
calculations, the more responsive the momentum will be to short-term
fluctuations, and vice versa. The signals triggered by the crossing of the zero
line remain in effect. However, they should be followed only when they are
consistent with the ongoing trend.
The Relative Strength Index (RSI)
The relative strength index is a popular oscillator devised by Welles
Wilder. The RSI measures the relative changes between the higher and lower
closing prices. (See Figure 5.43.)
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Figure 5.43. An example of the RSI oscillator
The formula for calculating the RSI is:
Л5/=100-[100/(1+RS)], where
RS - (average of X days up closes/average of X days down
closes);
X - predetermined number of days The original number of
days, as used by its author, was 14 days. Currently, a 9-day
period is more popular.
The RSI is plotted on a 0 to 100 scale. The 70 and 30 values are used
as warning signals, whereas values above 85 indicate an overbought
condition (selling signal) and values under 15 indicate an oversold condition
(buying signal.) Wilder identified the RSI's forte as its divergence versus the
underlying price.
Rate of Change (ROC)
The rate of change is another version of the momentum oscillator. The
difference consists in the fact that, while the momentum's formula is based
on subtracting the oldest closing price from the most recent, the ROC's
formula is based on dividing the oldest closing price into the most recent one.
(See Figure 5.44.)
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Figure 5.44. An example of the rate of change (ROC) oscillator
ROC = (CCP/OCP) * 100, where
CCP - current closing price;
OCP = old closing price for the predetermined period Larry
Williams %R.
The Larry Williams %R
The Larry Williams %R is a version of the stochastics oscillator. It
consists of the difference between the high price of a predetermined number
of days and the current closing price, which difference in turn is divided by
the total range. This oscillator is plotted on a reversed 0 to 100 scale.
Therefore, the bullish reversal signals occur at under 80 percent, and the
bearish signals appear at above 20 percent. The interpretations are similar to
those discussed under stochastics. (See Figure 5.45.)
Commodity Channel Index (CCI)
The commodity channel index was developed by Donald Lambert. It
consists of the difference between the mean price of the currency and the
average of the mean price over a predetermined period of time (See Figure
5.46.). A buying signal is generated when the price exceeds the upper (+100)
line, and a selling signal occurs when the price dips under the lower (-100)
line. (See Figure 5.46.)
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Figure 5.45. An example of the Larry Williams %R oscillator
Figure 5.46. An example of the commodity channel index
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Bollinger Bands
The Bollinger bands combine a moving average with the instrument's
volatility. The bands were designed to gauge whether prices are high or low
on a relative basis via volatility. The two are plotted two standard deviations
above and below a 20-day simple moving average.
The bands look a lot like an expanding and contracting envelope model.
When the band contracts drastically, the signal is that volatility is low and
thus likely to expand in the near future. An additional signal is a succession of
two top formations, one outside the band followed by one inside. If it occurs
above the band, it is a selling signal. When it occurs below the band, it is a
buying signal. (See Figure 5.47.)
The Parabolic System (SAR)
The parabolic system is a stop-loss system based on price and time.
The system was devised to supplement the inadvertent gaps of the other
trend-following systems. The name of the system is derived from its parabolic
shape, which follows the price gyrations. It is represented by a dotted line.
When the parabola is placed under the price, it suggests a long position.
Conversely, when placed above the price, the parabola indicates a short
position. (See Figure 5.48.) The parabolic system can be used with oscillators.
SAR stands for stop and reverse. The stop moves daily in the direction of the
new trend. The built-in acceleration factor pushes the SAR to catch up with
the currency price. If the new trend fails, the SAR signal will be generated.
The Directional Movement Index (DMI)
The directional movement index provides a signal of trend presence in
the market. The line simply rates the price directional movement on a scale
of0 to 100. The higher the number, the better the trend potential of a
movement, and vice versa. (See Figure 5.49.) This system can be used by
itself or as a filter to the SAR system.
Traders use different combinations of technical tools in their daily
trading and analysis. Some of the more popular oscillators are shown in
Figure 5.50.
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Figure 5.47. A market example of Bollinger bands
Figure 5.48. An example of the SAR parabolic study
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Figure 5.49. Example of the directional movement index (DMI)
Figure 5.50. Example of oscillator combinations used for trading
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CHAPTER 6
Fibonacci Analysis and
Elliott Waves Theory
6.1. Fibonacci Analysis
The Fibonacci analysis gives ratios which play important role in the
forecasting of market movements. This theory is named after Leonardo
Fibonacci of Pisa, an Italian mathematician of the late twelfth and early
thirteenth centuries He introduced an additive numerical series - Fibonacci
sequence.
The Fibonacci sequence consists of the following series of numbers:
1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, 377, 610, 987,
1597, 2584, 4181, (etc.), which exhibit several remarkable relationships,
in particular the ratio of any term in the series to the next higher term. This
ratio tends asymptotically to 0.618 (the Fibonacci ratio). In addition, the ratio
of any term to the next lower term in the sequence tends asymptotically to
1.618, which is the inverse of 0.618. Similarly constant ratios exist between
numbers two terms
Golden spirals appear in a variety of natural objects, from seashells to
hurricanes to galaxies.
The financial markets exhibit Fibonacci proportions in a number of
ways, particularly it constitute a tool for calculating price targets and placing
stops. For example, if a correction is expected to retrace 61.8 percent of the
preceding impulse wave, an investor might place a stop slightly below that
level. This will ensure that if the correction is of a larger degree of trend than
expected, the investor will not be exposed to excessive losses. On the other
hand, if the correction ends near the target level, this outcome will increase
the probability that the investor's preferred price move interpretation is
accurate.
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6.2. The Elliott Waves
Basics of Wave Analysis
The Elliott waves principle is a system of empirically derived rules for
interpreting action in the markets. Elliott pointed out that the market unfolds
according to a basic rhythm or pattern of five waves in the direction of the
trend at one larger scale and three waves against that trend. In a rising
market, this five wave/three-wave pattern forms one complete bull
market/bear market cycle of eight waves. The five-wave upward movement
as a whole is referred to as an impulse wave, and the three-wave
countertrend movement is described as a corrective wave (See Figure 6.1).
Within the five-wave bull move, waves 1, 3 and 5 are themselves impulse
waves, subdividing into five waves of smaller scale; while waves 2 and 4 are
corrective waves, subdividing into three smaller waves each. As shown in
Figure 6.1, subwaves of impulse sequences are labeled with numbers, while
subwaves of corrections are labeled with letters.
Figure 6.1. The basic Elliott Wave pattern
Following the cycle shown in the illustration, a second five-wave upside
movement begins, followed by another three-wave correction, followed by
one more five-wave up move. This sequence of movements constitutes a five-
wave impulse pattern at one larger degree of trend, and a three-wave
corrective movement at the same scale must follow. Figure 6.2 shows this
larger-scale pattern in detail.
As the illustration shows, waves of any degree in any series can be
subdivided and resubdivided into waves of smaller degree or expanded into
waves of larger degree.
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Figure 6.2. The larger pattern in detail
The following rules are applicable to the interpretation of Elliott Waves:
1. A second wave may never retrace more than 100 percent of a first
wave; for example, in a bull market, the low of the second wave may not go
below the beginning of the first wave.
2. The third wave is never the shortest wave in an impulse sequence;
often, it is the longest.
3. A fourth wave can never enter the price range of a first wave, except
in one specific type of wave pattern, the form of market movements is
essentially the same, irrespective of the size or duration of the movements.
Furthermore, smaller-scale movements link up to create larger-scale
movements possessing the same basic form. Conversely, large-scale
movements consist of smaller-scale subdivisions with which they share a
geometric similarity. Because these movements link up in increments of five
waves and three waves, they generate sequences of numbers that the analyst
can use (along with the rules of wave formation) to help identify the current
state of pattern development, as shown in Figure 6.3.
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Figure 6.3. A complete market cycle
As the market swings of any degree tend to move more easily with the
trend of one larger degree than against it, corrective waves often are difficult
to interpret precisely until they are finished. Thus, the terminations of
corrective waves are less predictable than those of impulse waves, and the
wave analyst must exercise greater caution when the market is in a
meandering, corrective mood than when prices are in a clearly impulsive
trend. Moreover, while only three main types of impulse wave exist, there
much more basic corrective wave patterns, and they can link up to form
extended corrections of great complexity. A most important thing to
remember about corrections is that only impulse waves can be “fives”. Thus,
an initial five-wave movement against the larger trend is never a complete
correction, but only part of it.
Impulse Wave Variations
In any given five-wave sequence, a tendency exists for one of the three
impulse subwaves (i.e., wave 1, wave 3, or wave 5) to be an extension—an
elongated movement, usually with internal subdivisions. At times, these
subdivisions are of nearly the same amplitude and duration as the larger
degree waves of the main impulse sequence, giving a total count of nine
waves of similar size rather than the normal count of five for the main
sequence. In a nine-wave sequence, it is sometimes difficult to identify which
wave is extended. However, this is usually irrelevant, because a count of nine
and a count of five have the same technical significance. Figure 6.4. shows
why this is so; examples of extensions in various wave positions make it clear
that the overall significance is the same in each case. Extensions can also
occur within extensions. Although extended fifth waves are not uncommon,
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extensions of extensions occur most often within third waves, as shown in
Figure 6.5.
Figure 6.4. Wave extensions
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Figure 6.5. Wave extensions
Extensions can provide a useful guide to the lengths of future waves.
Most impulse sequences contain extensions in only one of their three
impulsive subwaves. Thus, if the first and third waves are of about the same
magnitude, the fifth wave probably will be extended, especially if volume
during the fifth wave is greater than during the third.
The Diagonal Triangles
There are some patterns familiar from the Technical Analysis theory,
particularly two types of triangles, which should be noticed in frame of Elliotts
waves consideration.
The diagonal triangle type 1 occurs only in fifth waves and in С waves,
and it signals that the preceding move has, in accordance to Elliott, "gone too
far, too fast." All of the patterns' sub-waves, including waves 1, 3, and 5,
consist of three-wave movements, and their fourth waves often enter the
price range of their first waves, as shown in Figures 6.6. and 6.7. A rising
diagonal triangle type 1 is bearish, because it is usually followed by a sharp
decline, at least to the level where the formation began. In contrast, a falling
diagonal type 1 is bullish, because an upward thrust usually follows.
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Figure 6.6. A bullish pattern
Figure 6.7. A bearish pattern
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The diagonal triangle type 2 occurs even more rarely than type 1. This
pattern, found in first-wave or A-wave positions in very rare cases, resembles
a diagonal type 1 in that it is defined by converging trendlines and its first
wave and fourth wave overlap, as shown in Figure 6.8. However, it differs
significantly from type 1 in that its impulsive subwaves (waves 1, 3, and 5)
are normal, five-wave impulse waves, in contrast to the three-wave subwaves
of type 1. This is consistent with the message of the type 2 diagonal triangle,
which signals continuation of the underlying trend, in contrast to the type 1 's
message of termination of the larger trend.
Figure 6.8.
Failures (Truncated Fifths)
Elliott described as a failure an impulse pattern in which the extreme of
the fifth wave fails to exceed the extreme of the third wave. Figures 6.9 and
6.10 show examples of failures in bull and bear markets. As the illustrations
show, the truncated fifth wave contains the necessary impulsive (i.e., five-
wave) substructure to complete the larger movement. However, its failure to
surpass the previous impulse wave's extreme signals weakness in the
underlying trend, and a sharp reversal usually follows.
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Figure 6.9. Bull market failure
Figure 6.10. Bear market failure
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CHAPTER 7
Foreign Exchange Risks
On the foreign exchange market one discerns the following kinds of the
risks:
• exchange rate risk;
• interest rate risk;
• credit risk;
• country risk.
7.1. Exchange Rate Risk
Exchange rate risk is a consequence of the continuous shift in the
worldwide market supply and demand balance on an outstanding foreign
exchange position. A position will be a subject to all the price changes as long
as it is outstanding. In order to cut losses short and ride profitable positions
that losses should be kept within manageable limits. The most popular steps
are the position limit and the loss limit. The limits are a function of the policy
of the banks along with the skills of the traders and their specific areas of
expertise. There are two types of position limits: daylight and overnight.
1. The daylight position limit establishes the maximum amount of a
certain currency which a trader is allowed to carry at any single time during.
The limit should reflect both the trader's level of trading skills and the amount
at which a trader peaks.
2. The overnight position limit which should be smaller than daylight
limits refers to any outstanding position kept overnight by traders. Really, the
majority of foreign exchange traders do not hold overnight positions.
The loss limit is a measure to avoid unsustainable losses made by
traders; which is enforced by the senior officers in the dealing center. The
loss limits are selected on a daily and monthly basis by top management.
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The position and loss limits can now be implemented more conveniently
with the help of computerized systems which enable the treasurer and the
chief trader to have continuous, instantaneous, and comprehensive access to
accurate figures for all the positions and the profit and loss. This information
may also be delivered from all the branches abroad into the headquarters
terminals.
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7.2. Interest Rate Risk
Interest rate risk is pertinent to currency swaps, forward out rights,
futures, and options. It refers to the profit and loss generated by both the
fluctuations in the forward spreads and by forward amount mismatches and
maturity gaps among transactions in the foreign exchange book. An amount
mismatch is the difference between the spot and the forward amounts. For an
active forward desk the complete elimination of maturity gaps is virtually
impossible. However, this may not be a serious problem if the amounts
involved in these mismatches are small. On a daily basis, traders balance the
net payments and receipts for each currency through a special type of swap,
called tomorrow/next or rollover.
To minimize interest rate risk, management sets limits on the total size
of mismatches. The policies differ among banks, but a common approach is to
separate the mismatches, based on their maturity dates, into up to six
months and past six months. All the transactions are entered in computerized
systems in order to calculate the positions for all the delivery dates and the
profit and loss. Continuous analysis of the interest rate environment is
necessary to forecast any changes that may impact on the outstanding gaps.
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7.3. Credit Risk
Credit risk is connected with the possibility that an outstanding currency
position may not be repaid as agreed, due to a voluntary or involuntary action
by a counter party. In these cases, trading occurs on regulated exchanges,
where all trades are settled by the learing house. On such exchanges, traders
of all sizes can deal without any credit concern.
The following forms of credit risk are known:
1. Replacement risk which occurs when counter parties of the failed
bank find their books unbalanced to the extent of their exposure to the
insolvent party. To rebalance their books, these banks enter new
transactions.
2. Settlement risk which occurs because of different time zones on
different continents. Such a way, currencies may be credited at different
times during the day. Australian and New Zealand dollars are credited first,
then Japanese yen, followed by the European currencies and ending with the
U.S. dollar. Therefore, payment may be made to a party that will declare
insolvency (or be declared insolvent) immediately after, but prior to executing
its own payments.
The credit risk for instruments traded off regulated exchanges is to be
minimized through the customers' creditworthiness. Commercial and
investment banks, trading companies, and banks' customers must have credit
lines with each other to be able to trade. Even after the credit lines are
extended, the counter parties financial soundness should be continuously
monitored. Along with the market value of their currency portfolios, end
users, in assessing the credit risk, must consider also the potential portfolios
exposure. The latter may be determined through probability analysis over the
time to maturity of the outstanding position. For the same purposes netting is
used. Netting is a process that enables institutions to settle only their net
positions with one another not trade by trade but at the end of the day, in a
single transaction. If signs of payment difficulty of a bank are shown, a group
of large banks may provide short-term backing from a common reserve pool.
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7.4. Country Risk
The failure to receive an expected payment due to government
interference amounts to the insolvency of an individual bank or institution, a
situation described under credit risk. Country risk refers to the government's
interference in the foreign exchange markets and falls under the joint
responsibility of the treasurer and the credit department. Outside the major
economies, controls on foreign exchange activities are still present and
actively implemented.
For the traders it is important to know or be able to anticipate any
restrictive changes concerning the free flow of currencies. If this is possible,
though trading in the affected currency will dry up considerably, it is still a
manageable situation.
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Glossary And
Foreign Exchange
Terms
A
Accumulation swing index (ASI) An oscillator based on the swing index
(SI.) A buying signal is generated when the daily high exceeds the
previous SI significant high, and a selling signal occurs when the
daily low dips under the significant SI low.
American style currency option An option that may be exercised at any
valid business date throughout the life of the option.
Arbitrage A risk-free type of trading in which the same instrument is
bought and sold simultaneously in two different markets in order to
cash in on the divergence between the two markets.
Ascending triangle A triangle continuation formation with a flat upper
trendline and a bottom sloping upward trendline. (See Triangle.)
Ascending triple top A bullish point-and-figure chart formation that
suggests that the currency is likely to break a resistance line the
third time it reaches it. Each new top is higher than the previous
one.
Atekubi A bearish two-day candlestick combination. It consists of a
blank bar that closes at the daily high; the current closing price
equals the previous day's low. The original day's range is a long
black bar.
At par forward spread Forward price is zero; therefore, the spot price is
similar to the forward price. It reflects the fact that the foreign
interest rate is similar to the U.S. interest rate for that particular
period.
At-the-money (ATM) option An option whose present currency price is
approximately equal to the strike price.
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At the price stop-loss order A stop-loss order that must be executed at
the precise requested level, regardless of market conditions.
Average options Options that refer to the average rate of the
underlying currency that existed during the life of the option. This
rate becomes the strike in the case of the average strike options; or
it becomes the underlying, determining the intrinsic value when
compared to a predetermined fixed strike in the case of average rate
options. Average options can be based on the spot rate (spot style)
or on the forward underlying the option (forward style.) The average
can be calculated arithmetically or geometrically, and the rates can
be tabulated with a variety of frequencies.
B
Balance-of-payments All the international commercial and financial
transactions of the residents of one country.
Bank of Canada (BOC) The central bank of Canada.
Bank of England (BOE) The central bank of the United Kingdom. It is a
less independent central bank. The government may overwrite its
decision.
Bank of France (BOF) The central bank of France.
Bank of Italy (BOI) The central bank of Italy.
Bank of Japan (BOJ) The Japanese central bank. Although its Policy Board
is still fully in charge of the monetary policy, changes are still subject
to the approval of the Ministry of Finance (MOF). The BOJ targets
the M2 aggregate.
Bar chart A type of chart that consists of four significant points: the
high and the low prices, which form the vertical bar; the opening
price, which is marked with a little horizontal line to the left of the
bar; and the closing price, which is marked with a little horizontal line
to the right of the bar.
Barrier options (trigger options, cutoff options, cutout options, stop options,
down/up-and-outs/ins, knockups) Options very similar to
European style vanilla options, except that a second strike price (the
trigger) is specified that, when reached in the market, automatically
causes the option to be expired (knockout options) or "inspired"
(knockin options).
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Bearish tasuki A bearish two-day candlestick combination. It consists
of a long blank bar that has a low above 50 percent of the previous
day's long black body, and closes marginally above the previous
day's high. The second day's rally is temporary, as it is caused only
by profit-taking. The sell-off is likely to continue the next day.
Bearish tsutsumi (the engulfing pattern) A bearish two-day candlestick
combination. It consists of a second-day bearish candlestick whose
body "engulfs" the previous day's small bullish body.
Bilateral grid An exchange rate system that links all the central
rates of the EMS currencies in terms of the ECU.
Black closing bozu A bearish candlestick formation that consists of a
long black bar (upper shadow).
Black marubozu (shaven head) A bearish candlestick formation that
consists of a long black bar (no shadow).
Black opening bozu A bearish candlestick formation that consists of a
long black bar (lower shadow).
Black-Scholes fair value model The original option pricing model, which
holds that a stock and the call option on the stock are comparable
investments and thus a risk less portfolio may be created by buying
the stock and selling the option on the stock, as a hedge. The
movement of the price of the stock is reflected by the movement of
the price of the option, but not necessarily by the same amplitude.
Therefore, it is necessary to hold only the amount of the stock
necessary to duplicate the movement of the price of the option.
Blank closing bozu A bullish candlestick formation that consists of a
long blank bar (lower shadow).
Blank marubozu (shaven head) A bullish candlestick formation that
consists of a long blank bar (no shadows).
Blank opening bozu A bullish candlestick formation that consists of a
long blank bar (upper shadow).
Bollinger bands A quantitative method that combines a moving
average with the instrument's volatility. The bands were designed to
gauge whether the prices are high or low on a relative basis. They
are plotted two standard deviations above and below a simple
moving average. The bands look like an expanding and contracting
envelope model. When the band contracts drastically, the signal is
that volatility will expand sharply in the near future. An additional
signal is a succession of two top formations, one outside the band
followed by one inside. If it occurs above the band, it is a selling
signal. When it occurs below the band, it is a buying signal.
Book method Point-and-figure chart's original name.
Box spread A compound option strategy that consists of four options with a
common expiration date: a long call and a short put at one strike
price, and a long put and a short call at a different strike price.
Breakaway gap A price gap that occurs in the beginning of a new
trend, many times at the end of a long consolidation period. It may
also appear after the completion of major chart formations.
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Breakout of a spread triple bottom A bearish point-and-figure chart
formation that suggests that the currency is likely to break a support
line the third time it reaches it. The currency failed to reach the
support line once.
Breakout of a spread triple top A bullish point-and-figure chart
formation that suggests that the currency is likely to break a
resistance line the third time it reaches it. The currency failed to
reach the resistance line once.
Breakout of a triple bottom A bearish point-and-figure chart formation
that suggests that the currency is likely to break a support line the
third time it reaches it.
Breakout of a triple top A bullish point-and-figure chart formation that
suggests that the currency is likely to break a resistance line the third
time it reaches it.
Bullish tasuki A bullish two-day candlestick combination. It consists
of a long black bar that has a high above 50 percent of the previous
day's long blank body, and closes marginally below the previous
day's low.
Bullish tsutsumi (the engulfing bar) A bullish two-day candlestick
combination. It consists of a second bullish candlestick whose body
"engulfs" the previous day's small bearish body.
Bundesbank The German central bank. In addition to its domestic
obligations, the Bundesbank has had international obligations since
1979 as the front player of the European Monetary System. The
Bundesbank is a very independent central bank.
Business firms (establishment) survey Survey of the payroll, workweek,
hourly earnings, and total hours of employment in the non farm
sector.
Business Inventories An economic indicator that consists of the items
produced and held for future sale.
Butterfly spread A compound option strategy that consists of a combination
of a bull spread and a bear spread, using either calls or puts.
C
Calendar combination A compound option strategy that consists of the
simultaneous call calendar spread and put calendar spread, in which
the strike price of the calls is higher than the strike price of the puts.
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Calendar spread A combination option of two similar types of options,
either calls or puts, with the same strike price but different expiration
dates. The dissimilarity between the expiration dates allows this type
of spread to capitalize on both the impact of the time decay and the
interest rate differentials.
Calendar straddle A compound option strategy that consists of
simultaneous buying of a longer-term straddle and a near-term
straddle with a common strike price.
Call ratio backspread A compound option strategy that consists of
short calls with a lower strike price and more long calls with a higher
strike price. The profit is twofold. The maximum upside profit
potential is unlimited. The downside profit potential consists of the
total premium received. The maximum loss potential occurs when
the currency price reaches the higher strike price at expiration.
Candlestick chart A type of chart that consists of four major prices: high,
low, open, and close. The body (jittai) of the candlestick bar is
formed by the opening and closing prices. To indicate that the
opening was lower than the closing, the body of the bar is left blank.
If the currency closes below its opening, the body is filled. The rest
of the range is marked by two "shadows": the upper shadow
(uwakage) and the lower shadow (shitakage).
Capacity utilization An economic indicator that consists of total industrial
output divided by total production capability. The term refers to the
maximum level of output a plant can generate under normal
business conditions.
Cardinal square A Gann technique for forecasting future significant
chart points by counting from the all-time low price of the currency.
It consists of a square divided by a cross into four quadrants. The
all-time low price is housed in the center of the cross. All of the
following higher prices are entered in clockwise order. The numbers
positioned in the cardinal cross are the most significant chart points.
Channel line A parallel line that can be traced against the trendline,
connecting the significant peaks in an uptrend, and the significant
troughs in a downtrend.
Chaos theory A theory that holds that statistically noisy behavior may
occur randomly, even in simple environments. This seemingly
random behavior may be predicted with decreasing accuracy if the
source is known.
CHIPS (Clearing House Interbank Payments System) A computerized
system used for foreign exchange dollar settlements.
Christmas tree spread A compound option strategy that consists of
several short options at two or more strike prices.
Classes of options The types of options: calls and puts.
Combination spread (synthetic future) A compound option strategy
that consists of a long call and a short put, or a long put and a short
call, with a common expiration date.
FOREX. On-line Manual For Successful Trading 113
Commodity Channel Index (CCI) An oscillator that consists of the
difference between the mean price of the currency and the average
of the mean price over a predetermined period of time. A buying
signal is generated when the price exceeds the upper (+100) line,
and a selling signal occurs when the price dips under the lower (-
100) line.
Commodity Futures Trading Commission (CFTC) An independent agency
created by Congress in 1974 with a mandate to regulate commodity
futures and options markets in the United States. The CFTC's
responsibilities are to ensure the economic utility of futures markets,
via competitiveness and efficiency; ensure the integrity of these
markets; and protect the participants against manipulation, fraud,
and abusive practices. The Commission, based in Washington, D.C.,
regulates the activities of 285 commodity brokerage firms; 48,211
salespeople; 8017 floor brokers; 1325 commodity pool operators
(CPOs); 2733 commodity trading advisers (CTAs); and 1486
introducing brokers (IBs).
Commodity Research Bureau's (CRB) Futures Index Index formed from
the equally weighted futures prices of 21 commodities. The
preponderance of food commodities makes the CRB Index less
reliable in terms of general inflation.
Common gap A price gap that occurs in relatively quiet periods or in
illiquid markets. It has limited technical significance.
Condor spread A compound option strategy that consists of either
four same-type options with a common expiration date—two long
options with consecutive strike prices, one short option with an
immediately lower strike price, and one short option with an
immediately higher strike price; or four same-type options with a
common expiration date—two short options with consecutive strike
prices, one long option with an immediately lower strike price, and
one long option with an immediately higher strike price.
Consumer Price Index (CPI) An economic indicator that gauges the
average change in retail prices for a fixed market basket of goods
and services.
Consumer sentiment A survey of households designed to gauge the
individual propensity for spending. There are two studies conducted
in this area, one survey by the University of Michigan, and the other
by the National Family Opinion for the Conference Board. The
confidence index measured by the Conference Board is sensitive to
the job market, whereas the index generated by the University of
Michigan is not.
Continuation patterns Technical signals that reinforce the current trends.
Cost of carry The interest rate parity, whereby the forward price is
determined by the cost of borrowing money in order to hold the
position.
Council of Ministers The legislative body of the European Economic
Community in charge of making the major policy decisions. It is
FOREX. On-line Manual For Successful Trading 114
composed of ministers from all the 12 member nations. The
presidency rotates every six months by all the 12 members, in
alphabetical order. The meetings take place in Brussels or in the
capital of the nation holding the presidency.
Country (sovereign) risk A trading risk emerging from a
government's interference in the foreign exchange markets.
Covered interest rate arbitrage An arbitrage approach that consists of
borrowing currency A, exchanging it for currency B, investing
currency B for the duration of the loan, and, after taking off the
forward cover on maturity, showing a profit on the entire set of
deals.
Covered long A compound option strategy that consists of selling a
call against a long currency position. A covered long is synonymous
with a short put.
Covered short A compound option strategy that consists of shorting a
put against a short currency position. A covered short is synonymous
with a short call.
Cox, Ross, and Rubinstein pricing model An option pricing model that
takes into consideration the early exercise provision of the American
style options. As it assumes that early exercise will occur only if the
advantage of holding the currency exceeds the time value of the
option, their binomial method evaluated the call premium by
estimating the probability of early exercise for each successive day.
The theoretical premium is compared to the holding cost of the cash
hedge position, until the option's time value is worth less than the
forward points of the currency hedge and the option should be
exercised.
Credit risk The possibility that an outstanding currency position may
not be repaid as agreed, due to a voluntary or involuntary action by
a counterparty.
Cross rates Currencies traded against currencies other than the U.S.
dollar. A cross rate is a non-dollar currency.
Currency call A contract between the buyer and seller that holds that the
buyer has the right, but not the obligation, to buy a specific quantity
of a currency at a predetermined price and within a predetermined
period of time, regardless of the market price of the currency. The
writer assumes the obligation of delivering the specific quantity of a
currency at a predetermined price and within a predetermined period
of time, regardless of the market price of the currency, if the buyer
wants to exercise the call option.
Currency fixings An open auction executed in Europe on a daily basis in
which all players, regardless of size, are welcome to participate with
any amount.
Currency futures A specific type of forward outright deal with
standardized expiration date and size of the amount.
Currency option A contract between a buyer and a seller, also known
as writer, that gives the buyer the right, but not the obligation, to
FOREX. On-line Manual For Successful Trading 115
trade a specific quantity of a currency at a predetermined price and
within a predetermined period of time, regardless of the market price
of the currency; and gives the seller the obligation to deliver or buy
the currency under the predetermined terms, if and when the buyer
wants to exercise the option.
Currency put A contract between the buyer and the seller that holds
that the buyer has the right, but not the obligation, to sell a specific
quantity of a currency at a predetermined price and within a
predetermined period of time, regardless of the market price of the
currency. The writer assumes the obligation to buy the specific
quantity of a currency at a predetermined price and within a
predetermined period of time, regardless of the market price of the
currency, if the buyer wants to exercise the call option.
Current account balance The broadest current dollar measure of U.S.
trade, which incorporates services and unilateral transfers into the
merchandise trade data.
D
Daylight position limit The maximum amount of a certain currency a
trader is allowed to carry at any single time, between the regular
trading hours.
Dead cross An intersection of two consecutive moving averages that
move in opposite directions and should technically be disregarded.
Dealing systems On-line computers that link the contributing banks
around the world on a one-on-one basis.
Delta (A) (1) The change of the currency option price relative to a change
in the currency price; (2) the hedge ratio between the option
contracts and the currency futures contracts necessary to establish a
neutral hedge; (3) the theoretical or equivalent share position. In the
third case, delta is the number of currency futures contracts a call
buyer is long or a put buyer is short. Delta ranges between 0 and 1.
Descending triangle A triangle continuation formation with a flat
lower trendline and a downward-sloping upper trendline. (See
Triangle.)
Descending triple bottom Bearish point-and-figure chart formation
that suggests that the currency is likely to break a support line the
third time it reaches it. Each new bottom is lower than the previous
one.
FOREX. On-line Manual For Successful Trading 116
Diagonal spread A compound option strategy that consists of several
same-type options, in which the long side and the short side have
different strike prices and different expirations.
Diamond A minor reversal pattern that resembles a diamond shape.
Direct dealing An aggressive approach in which banks contact each
other outside the brokers' market.
Directional Movement Index A signal of trend presence in the market.
The line simply rates the price directional movement on a scale of 0
to 100. The higher the number, the better the trend potential of a
movement, and vice versa.
Discount forward spread A forward price that is deducted from a
spot price to calculate a forward price. It reflects the fact that the
foreign interest rate is lower than the U.S. interest rate for that
particular period.
Discount rate The interest rate at which eligible depository
institutions may borrow funds directly from the Federal Reserve
Banks. The rate is controlled by the Federal Reserve and is not
subject to trading.
Discretion for range to trader stop-loss order A stop-loss order that
gives the trader a number of discretionary pips within which the
order has to be filled.
Double bottoms A bullish reversal pattern that consists of two bottoms
of approximately equal heights. A parallel (resistance) line is drawn
against a line that connects the two bottoms. The break of the
resistance line generates a move equal in size to the price difference
between the average height of the bottoms and the resistance line.
Double tops A bearish reversal pattern that consists of two tops of
approximately equal heights. A parallel (support) line is drawn
against a resistance line that connects the two tops. The break of the
support line generates a move equal in size to the price difference
between the average height of the tops and the support line.
Downside tasuki gap A bearish two-day candlestick combination. It
consists of a second-day blank bar that closes an overnight gap
opened on the previous day by a black bar.
Downward breakout of a bearish support line A bearish point-and-
figure chart formation that confirms the currency's breakout of a
support line the third time it reaches it.
Downward breakout of a bullish support line A bearish point-and-
figure chart formation that confirms the currency's breakout of a
support line the third time it reaches it. The support line is sloped
upward.
Downward breakout from a consolidation formation A bearish point-
and-figure chart formation that resembles the inverse flag formation.
A valid downside breakout from the consolidation formation has a
price target equal in size to the length of the previous downtrend.
Durable Goods Orders An economic indicator that measures the
changes in sales of products with a life span in excess of three years.
FOREX. On-line Manual For Successful Trading 117
E
Economic exposure Reflects the impact of foreign exchange changes
on the future competitive position of a company.
Elliott Wave Principle A system of empirically derived rules for
interpreting action in the markets. It refers to a five-wave/three-
wave pattern that forms one complete bull market/bear market cycle
of eight waves.
Envelope model A band created by two winding parallel lines above
and below a short-term moving average that borders most price
fluctuations. When the upper band is penetrated, a selling signal
occurs; when the lower band is penetrated, a buying signal is
generated. Because the signals generated by the envelope model are
very short-term and occur many times against the ongoing direction
of the market, speed of execution is paramount.
Eurocurrency Currency deposit outside the country of origin.
Eurodollars U.S. dollar deposits placed in commercial banks outside the
United States.
European Coal and Steel Community European entity established in 1951
by the Treaty of Paris, with the purpose of promoting inter-European
trade in general, and eliminating restrictions on the trade of coal and
raw steel in particular. West Germany, France, Italy, the Netherlands,
Belgium, Luxembourg, and Great Britain formed this community.
European Commission The executive body of the European Economic
Community in charge of making and observing the enforcement of
policy. It consists of 23 departments, such as foreign affairs,
competition policy and agriculture. Each country selects its own
representatives for four-year terms, but the commissioners may only
act for the benefit of the community. The commission is based in
Brussels and consists of 17 members.
European Court of Justice The European Economic Community body in
charge of settling disputes between the EC and member nations. It
consists of 13 members and is based in Luxembourg.
European currency unit A basket of the member currencies. As a
composite unit, the ECU consists of all the European Community
currencies, which are individually weighted. It was created by the
European Monetary System with the eventual goal of replacing the
individual European member currencies.
European Economic Community A community established by the
Treaty of Rome in 1951, with the goal of eliminating customs duties
and any barriers against the transit of capital, services, and people
among the member nations. The signatories were West Germany,
France, Italy, the Netherlands, Belgium, and Luxembourg.
FOREX. On-line Manual For Successful Trading 118
European Joint Float Agreement European monetary system
established in April 1972 by the EC members: West Germany,
France, Italy, the Netherlands, Belgium, and Luxembourg. Great
Britain, Ireland, and Denmark were admitted by January 1973. The
agreement allowed the member currencies to move within a 2.25
percent fluctuation band (nicknamed the snake). As a joint group,
the agreement allowed these currencies to gyrate within a 4.5
percent band (nicknamed the tunnel). The entire agreement was
known as the snake in the tunnel.
European Monetary Cooperation Fund EMS fund established to
manage the EMS credit arrangements.
European Monetary Institute (EMI) The new European Central
Bank created to govern the EMS. As of March 1994, it did not have
any power over inter-EMS monetary policy.
European Monetary System European monetary system established in
March 1979 by seven full members: West Germany, France, the
Netherlands, Belgium, Luxembourg, Denmark, and Ireland. Great
Britain did not participate in all of the arrangements and Italy joined
under special conditions. New members: Greece in 1981, Spain and
Portugal in 1986. Great Britain joined the Exchange Rate Mechanism
in 1990. Also in 1990, West Germany became Germany as a result of
its political unification with East Germany.
European Parliament The European Economic Community body in
charge of reviewing and amending legislative proposals. It has the
power to reject the budget proposals. It consists of 518 members
who are elected. It is based in Luxembourg, but the sessions take
place in Strasbourg or Brussels.
European Payment Union European entity instituted in 1950 to
facilitate the inter-European settlements of international trade
transactions.
European-style currency option An option that may only be exercised on
the expiration date.
European Union Treaty Treaty signed by the 12 EMS members in
February 1992 in the Dutch city of Maastricht, with the stated goal of
forming a "closer union among the peoples of Europe."
Exchange for physical (EFP) Consists of deals executed in the cash
market, outside the exchanges, for amounts equivalent to the
currency futures amount, on forward outright prices valued for the
futures' expiration. EFPs are generally quoted by commercial and
investment banks, even during regular trading hours.
Exchange rate risk (1) Foreign exchange risk that is the effect of
the continuous shift in the worldwide market supply and demand
balance on an outstanding foreign exchange position. (2) Trading
risk pertinent to market fluctuation.
Exercise (strike) price The price at which the underlying currency will
be delivered upon exercise.
FOREX. On-line Manual For Successful Trading 119
Exhaustion gap Price gap that occurs at the top or the bottom of a V-
reversal formation. The trend changes direction in a rather
uncharacteristically quick manner.
Expanding (broadening) triangle A triangle continuation formation
that looks like a horizontal mirror image of a triangle; the tip of the
triangle is next to the original trend, rather than its base. (See
Triangle.)
Expiration date The delivery date.
Exponentially smoothed moving average A moving average that also
takes into account the previous price information of the underlying
currency.
F
Factory Orders An economic indicator that refers to total orders for
durable and nondurable goods. The nondurable goods orders consist
of food, clothing, light industrial products, and products designed for
the maintenance of the durable goods.
FASB # 8 (Financial Accounting Standards Board's Statement Number 8)
The original accounting rules regarding foreign exchange were
standardized in 1975, which set the procedures for foreign currency
translations into U.S. dollars in the consolidated balance sheets of
U.S. multinational corporations.
FASB # 52 (Financial Accounting Standards Board's Statement Number 52)
A complex set of rules designed in 1981, whose main objective is to
move the foreign exchange P&L from current income into
shareholders' equity.
Federal funds (Fed funds) Immediately available reserve balances at
the federal reserves. The Fed funds are widely used by commercial
banks or large corporations to lend to each other on an overnight
basis. Although their level is established by the Fed, the prices
fluctuate because they are traded in the market.
Federal Open Market Committee (FOMC) A committee established in
1935, through the Banking Act, to replace the Open Market Policy
Conference (OMPC.) Currently active.
Federal Reserve The central bank of the United States. It was
established in 1913 when Congress passed the Federal Reserve Act.
The Act held that role of the Federal Reserve was "to furnish an
elastic currency, to afford the means of rediscounting commercial
FOREX. On-line Manual For Successful Trading 120
paper, to establish a more effective supervision of banking in the
United States, and for other purposes."
Federal Reserve Board The board consists of a Governor and four other
regular members. The Secretary of the Treasury and the Comptroller
of the Currency are closely consulted. The 12 regional Federal
Reserve Banks around the country have sufficient autonomy to
manage financial conditions in their districts. They are also managed
by governors.
Fedwire An automated communications and settlement system
linking the Federal Reserve banks with other banks and with
depository institutions.
Fence A compound option strategy that consists of either a long
currency position—a long out-of-money put and a short out-of-the-
money call, where the options have the same expiration date (risk
conversion); or a short currency position—a short out-of-the-money
put and a long out-of-the-money call, where the options have the
same expiration date (risk reversal).
Fibonacci percentage retracements Price retracements of 0.382
and 0.618, or approximately 38 percent and 62 percent.
Fibonacci ratio 0.618 and 0.312.
Fibonacci sequence Takes a sequence of numbers that begins with 1
and adds 1 to it, then takes the sum of this operation (2) and adds it
to the previous term in the sequence (1). Next it takes the sum of
the second operation (3) and adds it to the previous term in the
sequence (the sum of the first operation, i.e., 2). The Fibonacci
sequence continues iterating in this manner, adding the most recent
sum to the previous term, which is itself the sum of the two previous
terms, etc. This yields the following series of numbers: 1 1 2 3 5 8 13
21 34 55 89 144 233 377 610 987 1597 2584 4181 (etc.).
FINEX A currency market that is part of the New York Cotton
Exchange (NYCE), the oldest futures exchange in New York. The
exchange lists futures on the European Currency Unit and the USDX,
a basket of ten currencies: deutsche mark, Japanese yen, French
franc, British pound, Canadian dollar, Italian lira, Dutch guilder,
Belgian franc, Swedish krona, and Swiss franc.
Fisher effect A theory holding that die nominal interest rate consists
of the real interest rate plus the expected rate of inflation.
Flag A continuation formation that resembles the outline of a
flag. It consists of a brief consolidation period within a solid and
steep upward trend or downward trend. The consolidation itself
tends to be sloped in the opposite direction from the slope of the
original trend, or simply flat. The consolidation is bordered by a
support line and a resistance line, which are parallel to each other or
very mildly converging, making it look like a flag (parallelogram). The
previous sharp trend is known as the flagpole. When the currency
resumes its original trend by breaking out of the consolidation, the
FOREX. On-line Manual For Successful Trading 121
price objective is the total length of the flagpole, measured from the
breakout price level.
Floor brokers Any individuals on the exchange floor engaged in
executing orders for another person. They may also trade for their
own accounts, with the primary responsibility of executing the
customers' orders first. Brokers are licensed by the federal
government.
Floor traders (locals) Exchange members who execute their own
trades by being physically present in the pit, or place for futures
trading.
Foreign exchange The mechanism that values foreign currencies in
terms of another currency.
Foreign exchange brokers Intermediaries among banks who bring
together buyers and sellers to the market, optimize the prices they
show to their customers, and do not take positions for themselves.
Foreign exchange exposure The potential effect of currency
fluctuations on shareholders' equity.
Foreign exchange rate The price of one currency in terms of another.
Forward outright Foreign exchange deal that matures at a day past the spot
delivery date (generally two business days).
Forward spread (forward points or forward pips) Forward price used to
adjust a spot price to calculate a forward price. It is based on the
current spot exchange rate, the interest rate differential, and the
number of days to delivery.
Fractal geometry Geometry theory that refers to the fact that certain
irregular objects have a fractal number of dimensions. In other
words, an object cannot fill an integer number of dimensions.
French-West German Treaty of Cooperation A treaty signed in 1963
by President Charles de Gaulle and Chancellor Konrad Adenauer,
which established that West Germany would lead economically
through the cold war and France, the former diplomatic powerhouse,
would provide the political leadership.
Fuzzy logic Method that attempts to weigh the quality of the patterns
recognized by neural networks. Because not all patterns have equal
financial significance for foreign currency forecasting, this method
qualifies the degree of certainty of the results.
G
Gamma The rate of change of an option's delta, or the sensitivity of
the delta.
FOREX. On-line Manual For Successful Trading 122
Gann percentage retracements The Gann theory focuses mostly on the
eighths, along with retracements in thirds.
Gap The price gap between consecutive trading ranges (i.e., the low of
the current range is higher than the high of the previous range).
Genetic algorithms Method used to optimize a neural network. Trial
and error are applied to an evolutionlike system, which mimics
natural selection for financial forecasting purposes.
GLOBEX An electronic trading system conceived in 1987 as an after-
hours trading system and geared toward global futures trading;
created through a joint venture of the Chicago Mercantile Exchange
(CME), the Chicago Board of Trade (CBT), and Reuters PLC.
Golden cross An intersection of two consecutive moving averages
that move in the same direction and suggest that the currency will
move in the same direction.
Gross Domestic Product The sum of all goods and services
produced in the United States.
Gross National Product The sum of government expenditure,
private investment, and personal consumption.
Gross National Product Implicit Deflator Deflator tool designed to
adjust the Gross National Product for inflation. It is calculated by
dividing the current dollar GNP figure by the constant dollar GNP
figure.
H
Harami bar A "wait-and-see" two-day candlestick combination. It
consists of two consecutive ranges having opposite directions, but it
does not matter which one is first. The second day's range results
fall within the previous day's body.
Head-and-shoulders A bearish reversal pattern that consists of a series of
three consecutive rallies, such that the first and third rallies (the
shoulders) have about the same height and the middle one (the
head) is the highest. The rallies are based on the same support line,
known as the neckline. When the neckline is broken, the price target
is approximately equal in amplitude to the distance between the top
of the head and the neckline.
Hedging A method used to minimize or eliminate the risk of
exchange rate fluctuations.
FOREX. On-line Manual For Successful Trading 123
High-low band A band created by two winding parallel lines above
and below a short-term moving average that borders most price
fluctuations. The moving average is based on the high and low
prices. The resulting two moving averages define the edges of the
band. A close above the upper band suggests a buying signal and a
close below the lower band gives a selling signal.
Hoshi (star) A "wait-and see" two-day candlestick combination. It
consists of a tiny body that appears the following day outside the
original body. It is not important whether the star reaches the
previous day's shadows. The direction of the two consecutive ranges
is also irrelevant.
Households survey Consists of the unemployment rate, the overall
labor force, and the number of people employed.
I
Implied volatility Method of measuring volatility by considering the
premiums currently trading in the market and calculating the figure
based on the level of the option premium.
In-the-money (ITM) call A call whose present currency price is higher
than the strike price.
In-the-money (ITM) put A put whose present currency price is lower than
the strike price.
Industrial Production An economic indicator that consists of the total
output of a nation's plants, utilities, and mines.
Initiation margin A margin paid by the trading party in order to trade
currency futures. A trader's daily loss cannot exceed the size of this
margin.
Interest rate risk Amount of mismatches and maturity gaps among
transactions in the foreign exchange book.
International Fisher effect Theory holding that investors will hold assets
denominated in depreciating currencies only to the extent that
interest rates are sufficiently high to balance the expected currency
losses.
FOREX. On-line Manual For Successful Trading 124
International Monetary Market The major currency futures and
options on currency futures market in the world. It is a division of
the Chicago Mercantile Exchange in Chicago.
Intrinsic value The amount by which an option is in-the-money. In
the case of a call, the intrinsic value equals the difference between
the underlying currency price and the strike price. In the case of the
put, the intrinsic value equals the difference between the strike price
and the present currency price, when beneficial.
Inverse head-and-shoulders A bullish reversal pattern that consists of a
series of three consecutive sell-offs. Among the three consecutive
sell-offs, the shoulders have approximately the same amplitude, and
the head is the lowest. The formation is based on a resistance line
called the neckline. After the neckline is penetrated, the target is
approximately equal in amplitude to the distance between the top of
the head and the neckline.
Irikubi A bearish two-day candlestick combination. It consists of a
modified atekubi bar. All the characteristics are the same, except
that the second day's closing high is marginally higher than the
original day's low.
Island reversal An isolated range or ranges that occur at the tip of a
V-formation.
ISO codes Standardized currency codes developed by the International
Organization for Standardization (ISO).
J
J-Curve theory Devaluation of a currency will trigger export gains in
the long term, rather than the short term, because of previous
contracts, existing inventories, and behavior modification.
Jittai Body of the candlestick (See Candlestick charts.)
Journal of Commerce Index Index that consists of the prices of 18
industrial materials and supplies used in the initial stages of
manufacturing, building, and energy production. It is more sensitive
than other indexes, as it was designed to signal changes in inflation
prior to the other price indexes.
FOREX. On-line Manual For Successful Trading 125
K
Kabuse (dark cloud cover) A bearish two-day candlestick
combination. It consists of a second-day long black bar that opens
above the high of the previous day's blank bar and closes within the
previous day's range (in an uptrend).
Karakasa (hangman at the top, hammer at the bottom) A bearish
candlestick at the top of the trend, bullish at the bottom of the trend.
The candlestick can be either blank or black. The body of the
candlestick is very small and only half the length of the shadow.
Kenuki (tweezers) A "wait-and-see" two-day candlestick combination. It
consists of consecutive bars that have matching highs or lows. In a
rising market, a tweezers top occurs when the highs match. The
opposite is true for a tweezers bottom.
Key reversal day The daily price range on the bar chart of the reversal
day fully engulfs the previous day's range; also, the close is outside
the preceding day's range.
Kirikomi A bullish two-day candlestick combination. It consists of a
blank marubozu bar that opens the second day lower (than the
previous low of a long black line) and closes above the 50 percent
level of the previous day's range.
Knockin A plain vanilla option that does not exist until the trigger is
reached. Knockout a plain vanilla option that goes away if the trigger
is reached.
Koma (spinning tops) A reversal candlestick formation that consists of
a short bar, either blank or black. This candlestick may also suggest
lack of direction.
L
Larry Williams %R A version of the stochastics oscillator. It consists
of the difference between the high price of a predetermined number
of days and the current closing price; that difference in turn is
divided by the total range. This oscillator is plotted on a reversed 0
to 100 scale. Therefore, the bullish reversal signals occur at under 80
FOREX. On-line Manual For Successful Trading 126
percent and the bearish signals appear at above 20 percent. The
interpretations are similar to those discussed under stochastics.
Leading Indicators Index An economic indicator designed to offer a
six- to nine-month future outlook of economic performance. It
consists of the following economic indicators: average workweek of
production workers in manufacturing; average weekly claims for
state unemployment; new orders for consumer goods and materials
(adjusted for inflation); vendor performance (companies receiving
slower deliveries from suppliers); contracts and orders for plant and
equipment (adjusted for inflation); new building permits issued;
change in manufacturers' unfilled orders for durable goods; change
in sensitive materials prices; index of stock prices; money supply,
adjusted for inflation; and the index of consumer expectations.
Line chart The line connecting single prices for each of the time
periods selected.
Linearly weighted moving average A moving average that assigns more
weight to the more recent closings.
Long legged shadows' doji A reversal candlestick formation that
consists of a bar in which the opening and closing prices are equal.
Long straddle A compound option that consists of a long call and a
long put on the same currency, at the same strike price, and with the
same expiration dates. The maximum loss for the buyer is the sum of
the premiums. The upside break-even point is the sum of the strike
price and the premium on the straddle. The downside break-even
point is the difference between the strike price and the premium on
the straddle. The profit is unlimited.
Long strangle A compound option that consists of a long call and a
long put on the same currency, at different strike prices, but with the
same expiration dates. The profit is unlimited.
M
Ml Money supply measure that is composed of currency in circulation
(outside the Treasury, the Fed, and depository institutions),
traveler's checks, demand deposits, and other checkable deposits
[negotiable order of withdrawal (NOW) accounts, automatic transfer
service (ATS) accounts, etc.].
M2 Money supply measure that consists of Ml plus repurchase
agreements, overnight Eurodollars, money market deposit accounts,
FOREX. On-line Manual For Successful Trading 127
savings and time deposits (in amounts under $100,000), and
balances in general accounts.
M3 Money supply measure that is composed of M2 plus time deposits
over $100,000, term Eurodollar deposits, and all balances in
institutional money market mutual funds.
Margin The amount of money or collateral deposited by a customer with
a broker, by a broker with a clearing member, or by a clearing
member with the clearinghouse in order to insure the broker or
clearinghouse against loss on outstanding futures positions.
Mark-to-market Daily cash flow system used by the U.S. futures
exchanges to maintain a minimum level of margin equity for a
specific currency future or option by calculating the profit and loss at
the end of each trading day in each contract position resulting from
the price fluctuation.
Matched sale-purchase agreements Daily operations executed by the
Federal Reserve, in which the Fed sells a security for immediate
delivery to a dealer or a foreign central bank, with the agreement to
buy back the same security at the same price at a predetermined
time in the future (generally within seven days). This arrangement
amounts to a temporary drain of reserves.
Matching systems Electronic systems duplicating the traditional
brokers' market. A price shown by a bank is available to all traders.
Maturity date The date when a foreign exchange contract expires.
Merchandise Trade Balance An economic indicator that consists of the
net difference between the exports and imports of a certain
economy. The data includes food, raw materials and industrial
supplies, consumer goods, autos, capital goods, and other
merchandise.
Momentum An oscillator designed to measure the rate of price change,
not the actual price level. This oscillator consists of the net difference
between the current closing price and the oldest closing price from a
predetermined period. The momentum is measured on an open scale
around the zero line.
Moving average An average of a predetermined number of prices over
a number of days, divided by the number of entries.
Moving average convergence-divergence (MACD) An oscillator that
consists of two exponential moving averages (other inputs may be
chosen by the trader as well) plotted against the zero line. The zero
line represents the times the values of the two moving averages are
identical. A buying signal is generated when this intersection is
upward, whereas a selling signal occurs when the intersection takes
place on the downside.
Moving averages oscillator An oscillator in which the values of two
consecutive moving averages are subtracted from each other (the
larger number of days from the previous one) and the new values
are plotted.
FOREX. On-line Manual For Successful Trading 128
N
Naked intervention (unsterilized intervention) A central bank
intervention in the foreign exchange market that consists solely of
the foreign exchange activity. This type of intervention has a
monetary effect on the money supply and a long-term effect on
foreign exchange.
National Association of Purchasing Managers Index (NAPM) A survey of 250
industrial purchasing managers, conducted in order to gauge the
changes in new orders, production, employment, inventories, and
vendor delivery speed.
National Futures Association (NFA) A self-regulatory organization
that consists of futures commission merchants (FCMs), commodity
pool operators (CPOs), commodity trading advisers (CTAs),
introducing brokers (IBs), leverage transaction merchants (LTMs),
commodity exchanges, commercial firms, and banks. It is responsible
for certain aspects of the regulation of FCMs, CPOs, CTAs, IBs, and
LTMs, focusing primarily on qualifications and proficiency, financial
conditions, retail sales practices, and business.
Netting A process that enables institutions to settle only their net
positions with one another at the end of the day, in a single
transaction, not trade by trade.
Neural networks Computer systems that recognize patterns. They may be
used to generate trading signals or to be part of trading systems.
Neutral spread (delta-neutral spread) A compound option strategy that
consists of a long option position and a short option position whose
respective total delta positions are relatively equal.
Next best price stop-loss order A stop-loss order that must be
executed after the requested level is reached.
Nonfarm sector Jobs in government, manufacturing, services,
construction, mining, retail and others.
Nostro account (clearing account) The account for each foreign
currency in the country of origin maintained by the financial
institutions for purchase and receiving (P&R) purposes.
FOREX. On-line Manual For Successful Trading 129
O
Open interest The total outstanding position in a currency.
Open Market Investment Committee (OMIC) Committee established in 1923
in order to coordinate the Reserve Bank operations. It was composed
of the Governors of the Federal Reserve Banks in New York, Boston,
Philadelphia, Chicago, and Cleveland. Not currently active.
Open Market Policy Conference (OMPC) Committee established in 1930
to replace the OMIC. It consisted of 12 Federal Reserve Banks
governors and the members of the Board. Not currently active.
Optimal options Options that refer to the most favorable rate of the
underlying currency that existed (from the holder's perspective)
during the life of the option. This rate becomes the strike in the case
of optimal strike options, or it becomes the underlying, determining
the intrinsic value when compared to a predetermined fixed strike in
the case of optimal rate options. Optimals can be based on the spot
rate (spot style) or the forward rate (forward style).
Option currency spread A long currency option and an offsetting short
currency option, generally in the same currency.
Option writers Option sellers.
Oscillators Quantitative methods designed to provide signals regarding
overbought and oversold conditions.
Out-of-the-money (OTM) call A call whose present currency price
is lower than the strike price.
Out-of-the-money (OTM) put A put whose present currency price
is higher than the strike price.
Overnight position limit A position kept overnight by traders.
P
Parabolic system A stop-loss technical system, based on price and time.
The system was devised to supplement the inadvertent gaps of the
other trend-following systems. Although not technically an oscillator,
the parabolic system can be used with the oscillators. SAR stands for
stop-and-reverse. The stop moves daily in the direction of the new
trend. The built-in acceleration factor pushes the SAR to catch up
with the currency price. If the new trend fails, the SAR signal will be
generated. The name of the system is derived from its parabolic
shape, which follows the price gyrations. It is represented by a
FOREX. On-line Manual For Successful Trading 130
dotted line. When the parabola is placed under the price, it suggests
a long position. Conversely, a price above the parabola indicates a
short position.
Pennants A continuation formation that resembles the outline of a
pennant. It consists of a brief consolidation period within a solid and
steep upward trend or downward trend. The consolidation itself
tends to be sloped in the opposite direction from the slope of the
original trend, or simply flat. The consolidation is bordered by a
support line and a resistance line, which converge, creating a
triangle. The previous sharp trend is known as the pennant pole.
When the currency resumes its original trend by breaking out of the
consolidation, the price objective is the total length of the pole,
measured from the breakout price level.
Personal Income An economic indicator that consists of the income
received by individuals, nonprofit institutions, and private trust funds.
Some of the components of this indicator are wages and salaries,
rental income, dividends, interest earnings, and transfer payments
(Social Security, state unemployment insurance, and veteran's
benefits).
Philadelphia Stock Exchange (PHLX) The oldest U.S. securities exchange,
it offers currency futures and options on currency futures.
Point-and-figure chart A type of chart that plots price activity without
regard to time. When the currency moves up, the fluctuations are
marked with X's. The moves on the downside are plotted with O's.
The direction on the chart only changes if the currency reverses by a
certain number of pips.
Premium The price of the option paid by the buyer to the seller.
Premium forward spread Forward price that is added to a spot price
to calculate a forward price. It reflects the fact that the foreign
interest rate is higher than the U.S. interest rate for that particular
period.
Prime rate The rate that commercial banks charge customers, which is
based on the discount rate.
Producer Price Index An economic indicator that gauges the average
changes in prices received by domestic producers for their output at
all stages of processing.
Purchasing power parity (PPP) Model of exchange rate
determination stating that the price of a good in one country should
equal the price of the same good in another country, exchanged at
the current rate (the law of one price).
Put-call-forward exchange parity (PCFP) theory A relationship between
a call option and a put option established through the forward
market. The theory holds that the option of buying the domestic
currency with a foreign currency at a certain price X is equivalent to
the option of selling the foreign currency with the domestic currency
at the same price X. Therefore, the call option in the domestic
currency becomes the put option in the other, and vice versa.
FOREX. On-line Manual For Successful Trading 131
Put ratio backspread A compound option strategy that consists of
short puts with a higher strike price and more long puts with a lower
strike price. The profit is twofold. The maximum upside profit
potential consists of the total premium received. The downside profit
potential is unlimited. The maximum loss potential occurs when the
currency price reaches the lower strike price at expiration.
R
Random walk theory An efficient market hypothesis, stating that
prices move randomly versus their intrinsic value. Therefore, no one
can forecast market activity based on the available information.
Rate of change A momentum oscillator in which the oldest closing
price is divided into the most recent one.
Ratio call spread A compound option strategy that consists of a number
of long calls with lower strike prices and a larger number of short
calls with a higher strike price. The maximum profit is realized when
the currency price is at the higher strike price. This combination has
two break-even points. The downside break-even point consists of
the sum of the lower strike price and the debit, divided by the
number of long calls. The upside break-even point consists of the
sum of the higher strike price and the maximum profit potential,
divided by the number of naked calls. The maximum loss is twofold.
The maximum downside risk is the net premium. The upside risk is
unlimited.
Ratio put spread A compound option strategy that consists of a number
of long puts with higher strike prices and a larger number of short
puts with a lower strike price. The maximum profit is realized when
the currency price is at the lower strike price. This combination has
two break-even points. The downside break-even point consists of
the difference between the lower strike price and the maximum
profit potential, divided by the number of naked puts. The upside
break-even point consists of the difference between the higher strike
price and the debit, divided by the number of long calls. The
maximum loss is twofold. The maximum downside risk is unlimited.
The upside risk is the net premium.
FOREX. On-line Manual For Successful Trading 132
Ratio spread A compound option strategy in which the number of
long options is different from the number of short options.
Rectangle A continuation formation that resembles the outline of a
parallelogram. The price objective is the height of the rectangle.
Regulation Q Regulation passed by the Federal Reserve that
prohibited payment of interest on demand deposits and prescribed
maximum rates banks could pay on time deposits. These ceilings had
been imposed since 1933 by the U.S. government. The regulation is
not currently in effect.
Relative Strength Index An oscillator that measures the relative
changes between the higher and lower closing prices. The RSI is
plotted on a 0 to 100 scale. The 70 and 30 values are used as
warning signals, whereas values above 85 indicate an overbought
condition (selling signal), and values under 15 suggest an oversold
condition (buying signal).
Replacement risk A form of credit risk that holds that
counterparties of failed banks will find their books unbalanced to the
extent of their exposure to the insolvent party. In order to rebalance
their books, these banks must enter new transactions.
Repurchase agreements (repos) Daily operations executed by the
Federal Reserve. A repurchase agreement between the Federal
Reserve and a government securities dealer consists of the Fed's
purchasing a security for immediate delivery, with the agreement to
sell the same security back at the same price at a predetermined
date in the future (usually within 15 days). This arrangement
amounts to a temporary injection of reserves in the banking system.
Resistance level The peaks representing the price level at which supply
exceeds demand.
Reversal patterns Patterns that occur at the end of the trend,
signaling the trend change.
Rollover (tomorrow/next or torn/next) swap A swap designed for spot
trades' maintenance. It was designed to change the old spot date to
the current spot date (on the front office's side) and to enable the
bank to make the payments to the counterparty (on the back office's
side).
Rounded bottom A bullish reversal pattern that consists of a very slow
and gradual change in the direction of the market.
Rounded top (saucer) A bearish reversal pattern that consists of a very
slow and gradual change in the direction of the market.
Runaway or measurement gap A price gap that occurs within solid
trends. It is also called a measurement gap because it tends to occur
about midway through the life of a trend.
FOREX. On-line Manual For Successful Trading 133
S
Sangu (three gaps) A reversal candlestick signal applicable in either
a steeply rising or falling market, when the daily limits will break the
trading. The theory holds that after the third gap, the market will
reverse at least to the second gap.
Sanpei (three parallel bars) A reversal candlestick combination. It
refers to the similarity in direction and velocity of three consecutive
bars, as otherwise all the entries are parallel. They generate a
reversal formation after an extended rally. When bullish, the
formation is known as the three soldiers. When bearish, the name is
the three crows.
Sanpo (three methods) A candlestick combination that advises that
retracements are in order before the market will reach new highs
and new lows.
Sansen (three rivers) method A reversal candlestick combination. It
consists of three daily entries. The first day is a long blank bar (a
bullish move), followed by a bullish but short-range one-day island.
The third entry is a bearish long black line.
Sanzan (three mountains) A reversal candlestick combination. It
consists of a triple-top formation.
Sashikomi A bearish two-day candlestick combination. It consists of a
modified irikubi bar. The difference is that the opening of the second
day's blank bar is much lower than that of the irikubi bars. Despite
the wider gap thus formed, the blank candlestick closes only slightly
above the previous day's low.
Settlement risk A form of credit risk that may occur due to the time
zones separating the nations. Payment may be made to a party who
will declare insolvency (or be declared insolvent) immediately after
receipt, but prior to executing its own payments.
Shitakage Lower shadow of the candlestick. (See Candlestick chart.)
Short straddle A compound option that consists of a short call and a
short put on the same currency, at the same strike price, and with
the same expiration dates. The maximum profit consists of the
combined premium of the two individual options. The loss occurs
when the level of the premium is overpassed by the currency swing,
and the loss is unlimited.
Short strangle A compound option that consists of a short call and a
short put on the same currency, with the same expiration dates, but
with different strike prices. The maximum profit consists of the
combined premium of the two individual options. The loss is
unlimited.
Simple moving average or arithmetic mean An average of a
predetermined number of prices over a number of days, divided by
the number of entries.
FOREX. On-line Manual For Successful Trading 134
Slow stochastics A version of the original stochastic oscillator. The new,
slow %K line consists of the original %D line. The new, slow %D line
formula is calculated from the new %K line.
Snake The nickname of the European Joint Float Agreement's 2.25
percent fluctuation band for the European currencies against each
other, derived from its curvaceous movement.
Speedlines Support or resistance lines that divide the range of the trend
into thirds on a vertical line. The two resulting speedlines are plotted
by using as coordinates the origin and the 1/3 and 2/3 prices
respectively.
Spot deal A foreign exchange deal that consists of a bilateral contract
between a party delivering a certain amount of a currency against
receiving a certain amount of another currency from a second
counterparty, based on an agreed exchange rate, within two
business days of the deal date. The exception is the Canadian dollar,
in which the spot delivery is executed within one business day.
Spot next (S/N) A foreign exchange deal that matures one business
day past the spot date, or three business days.
Sterilized intervention A central bank intervention in the foreign
exchange market that consists of a sale of government securities
that offsets the reserve injection which occurs due to the foreign
exchange intervention. The money market activity sterilizes the
impact of the foreign exchange intervention on the money supply.
Sterilized interventions have a short- to medium-term effect.
Stochastics Oscillators that consist of two lines called %K and %D.
Visualize %K as the plotted instrument and %D as its moving
average. The resulting lines are plotted on a 1 to 100 scale. Just as
in the case of the RSI, the 70 percent and 30 percent values are
used as warning signals. The buying (bullish reversal) signals occur
at under 10 percent and the selling (bearish reversal) signals come
into play at above 90 percent.
Strike price See Exercise price.
Support level The troughs representing the level at which demand
exceeds supply.
Swap deal A foreign exchange deal that consists of a spot deal and a
forward outright deal. A party simultaneously buys and sells (or sells
and buys) the same amount of a currency with another counterparty;
the two legs of the transaction mature on different dates (one of the
dates being the spot date) and are traded at different exchange rates
(one of the exchange rates being the spot rate). Exceptions may be
made with regard to the value dates (forward-forward) and amount
(different amounts).
SWIFT (Society of Worldwide Interbank Financial Telecommunications)
An automated system set up to send standardized payment
instructions for foreign currencies among international banks.
Swing Index (SI) A momentum oscillator that is plotted on a scale
of -100 to +100. The spikes reaching the extremes suggest reversal.
FOREX. On-line Manual For Successful Trading 135
Symmetrical triangle A triangle continuation formation in which the
support and resistance lines are symmetrical. (See Triangle.)
Synthetic call option A combination of a long currency and a long
currency put. Synthetic put option A combination of a short currency
and a long currency call.
T
Tan Book An economic report prepared by the Federal Reserve for
FOMC meetings.
Tankan Economic Survey The Japanese equivalent of the American
Tan Book, which is released by the Federal Reserve. The survey is
released on a quarterly basis.
Technical analysis The chart study of past behavior of commodity
prices for purposes of forecasting their future performance.
Theory of elasticities A model of exchange rate determination stating
that the exchange rate is simply the price of foreign exchange that
maintains the BOP in equilibrium. The degree to which the exchange
rate responds to a change in the trade balance depends entirely on
the elasticity of demand to a change in price.
Theta (T) or time decay Occurs as the very slow or nonexistent
movement of the currency triggers losses in the option's theoretical
value.
Three Buddha top formation A reversal candlestick combination. It
consists of a head-and-shoulders formation, or three consecutive
rallies in which the first and the third are of approximately the same
height, and the second is the highest.
Threshold of divergence A safety feature for the EMS that creates
an emergency exit for currencies that become the singular focus of
various adverse forces. The threshold of divergence indicates when
the specific country with the pressured currency should take
additional steps other than simple central bank intervention in the
foreign exchange markets.
Time decay See Theta.
Time value (time premium or extrinsic value) The difference between
the option premium and its intrinsic value.
Tohbu (gravestone doji) A reversal candlestick formation.
Tomorrow/next (T/N) deal A foreign exchange deal that matures the next
business day, or one day prior to the spot date.
FOREX. On-line Manual For Successful Trading 136
Tonbo (dragonfly) A reversal candlestick formation.
Traditional (Charles Dow) percentage retracements Occur at 33
percent, 50 percent, and 66 percent.
Transaction exposure Potential profit and loss generated by current
foreign exchange transactions.
Translation exposure The risk of change of the consolidated corporate
earnings as a result of past volatility in the base currency.
Trend The general direction of the market, as shown by the
significant peaks and troughs of the currency fluctuations.
Trendline A straight line connecting the significant highs (peaks) in a
downtrend, and the significant lows (troughs) in an uptrend.
Triangle A continuation formation that resembles the outline of a
pennant, but without the pole. It consists of a brief consolidation
period within a solid and steep upward trend or downward trend. The
consolidation itself tends to be sloped in the opposite direction from
the slope of the original trend, or simply flat. The consolidation is
bordered by converging support and resistance lines, making it look
like a triangle. When the currency resumes its original trend by
breaking out of the consolidation, the price objective is the height of
the triangle, measured from the breakout price level.
Triple bottom A bullish reversal pattern that consists of three bottoms of
approximately equal heights. A parallel—resistance—line is drawn
against a support line, which connects these tops. The break of the
resistance line generates a move equal in size to the price difference
between the average height of the bottoms and the resistance line.
Triple top A bearish reversal pattern that consists of three tops of
approximately equal heights. A parallel—support—line is drawn
against a resistance line, which connects these tops. The break of
the support line generates a moveequal in size to the price difference
between the average height of the topsand the support line. |
TRIX Index An oscillator that consists of a one-day ROC calculation of a
triple exponentially smoothed moving average of the closing price.
Tunnel The nickname of the European Joint Float Agreement's total
fluctuation band of the European currencies.
FOREX. On-line Manual For Successful Trading 137
U
Unemployment Rate An economic indicator released as a percentage
that is calculated as the ratio of the difference between the total
labor force and the employed labor force, divided by the total labor
force.
Upside gap tasuki Bullish two-day candlestick combination. It
consists of a second-day black bar that closes an overnight gap
opened on the previous day by a blank bar.
Upward breakout of a bearish resistance line Bullish point-and-figure
chart formation that confirms the currency's breakout of a resistance
line the third time it reaches it. The resistance line is sloped
downward.
Upward breakout of a bullish resistance line Bullish point-and-figure
chart formation that confirms the currency's breakout of a resistance
line the third time it reaches it.
Upward breakout from a consolidation formation Bullish point-and-figure
chart formation that resembles the flag formation. A valid upside
breakout from the consolidation formation has a price target equal in
size to the length of the previous uptrend.
USDX Currency index that consists of the weighted average of the
prices of ten foreign currencies against the U.S. dollar: deutsche
mark, Japanese yen, French franc, British pound, Canadian dollar,
Italian lira, Dutch guilder, Belgian franc, Swedish krona, and Swiss
franc.
Uwakage Upper shadow of the candlestick. (See Candlestick chart.)
V
Value at risk The expected loss from an adverse market movement, with
a specified probability over a particular period of time.
Variation (maintenance) margin Margin paid by the trading party in
order to fully cover any unrealized loss. Any trader holding an
overnight position with a negative P&L must post it in cash. It must
be kept on deposit at all times.
Vega The sensitivity of the theoretical value of an option to a change in
volatility.
FOREX. On-line Manual For Successful Trading 138
Velocity of money The rate at which money is turning over on an annual
basis to facilitate income transactions.
Vertical bear call spread A compound option strategy of buying two
options with a common expiration date; one option is a short call
with a lower strike price and the other is a long call with a higher
strike price. The seller's maximum profit is limited to the premium
paid for the two options. The break-even point is calculated as the
sum of the lower strike price and the total premium. The maximum
loss consists of the dollar difference between the two strike prices,
minus the total premium received.
Vertical bear put spread A compound option strategy of buying two
options with a common expiration date; one option is a long put with
a higher strike price and the other is a short put with a lower strike
price. The buyer's maximum profit consists of the dollar difference
between the two strike prices, minus the total premium paid. The
break-even point is calculated as the difference between the higher
strike price and the total premium. The maximum loss is limited to
the premium paid for the two options.
Vertical bear spread An option combination whose theoretical value
will decline to a predetermined maximum profit if the price of the
underlying currency declines and whose maximum loss is also
predetermined.
Vertical bull call spread A compound option strategy of buying two
options with a common expiration date; one option is a long call with
a lower strike price and the other is a short call with a higher strike
price. The buyer's maximum profit consists of the dollar difference
between the two strike prices, minus the total premium paid. The
break-even point is calculated as the sum of the lower strike price
and the total premium. The maximum loss is limited to the premium
paid for the two options.
Vertical bull put spread A compound option strategy of buying two
options with a common expiration date; one option is a long put with
a lower strike price and the other is a short put with a higher strike
price. The buyer's maximum profit consists of the net premium paid
for the two options (one paid, the other received). The break-even
point is calculated as the difference between the higher strike price
and the total premium received. The maximum loss is limited to the
dollar difference between the two strike prices, minus the total
premium received.
Vertical bull spread An option combination whose theoretical value
will rise to a predetermined maximum profit if the price of underlying
currency rises, and whose maximum loss is also predetermined.
Vertical spread A compound option that consists of two similar options
(i.e., calls or puts), one being bought and the other sold, on the
same currency and with the same expiration date, but with different
strike prices.
FOREX. On-line Manual For Successful Trading 139
V-formation (spike) Reversal formation that shows sudden trend
changes and is accompanied by heavy trading volume. This pattern
may include a key reversal day, or an island reversal and an
exhaustion gap.
Volatility The degree to which the price of currency tends to fluctuate
within a certain period of time.
Volume The total amount of currency traded within a period of time,
usually one day.
Vostro account A vostro account from the point of view of the
counterparty.
W
Wedge A continuation formation that resembles the outline of a
pennant, but without the pole. It consists of a brief consolidation period
within a solid and steep upward trend or downward trend. The consolidation
is sharply angled in the opposite direction from the slope of the original trend.
The consolidation is bordered by a support line and a resistance line that
converge, making it look like a sharply angled triangle. When the currency
resumes its original trend by breaking out of the consolidation, the price
objective is the height of the wedge, measured from the breakout price level.
FOREX. On-line Manual For Successful Trading 140
BIBLIOGRAPHY
1. Luca, C. Trading in the Global Currency Markets. 2nd Edition. New
York Institute of Finance. New York, 1999.
2. Luca, C. Technical Analysis Applications in the Global Currency
Markets. 2nd Edition. New York Institute of Finance. New York, 2000.
3. Achelis, S.B. Technical Analysis from A to Z. 2nd Edition. New York.
McGraw-Hill, 2000
4. An Introduction to Technical Analysis. John Wiley & Sons, 1999.
5. Edwards, R.D., Magee John. Technical Analysis of Stock Trends. 7th
Edition. AMACOM, 1998.
FOREX. On-line Manual For Successful Trading 141